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Company A and Company B are identical in all regards except that during Year 1 Company A borrowed $32,000 at an interest rate of 10%. In contrast, Company B obtained financing by acquiring $32,000 from sale of common stock. Company B agreed to pay a $3,200 cash dividend each year. Both companies are in a 30% tax bracket. Which company would show the greater retained earnings at the end of Year 1, and by what amount?

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Answer: Company A by $960

Explanation:

Interest as you may or may not know is tax deductible.

This means that whatever company A pays on the debt is tax deductible.

Calculating the tax deducted interest rate with a rate of 30% would be,

= 10% * ( 1 - 30%)

= 7%

That means their interest payment is,

= 7% * 32,000

= $2,240

Company B on the other hand will pay $3,200 in dividends every year.

= 3,200 - 2,240

= $960

Company A pays out $960 less than Company B does from it's retained earnings. This means that Company A will show a higher earnings amount.

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