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All right, so let's start with the corporate tax rate,

Â and this is just a very brief example that will show you the tax shelter,

Â the tax break that you have when you get debt in your capital structure.

Â Now, as you see there, there,

Â there are two companies and, and they're identical in every possible way.

Â We're only going to look at just a little bit of these companies, the,

Â the part that is interesting to us.

Â But as you see, in the second column, there's a few numbers that, for

Â a company that has no debt.

Â And in the third column there's few numbers for a company that has debt.

Â That company that has debt we're going to assume something very simple.

Â It has $100 million of debt, it pays an 8% interest on that debt.

Â Which means that 8% of 100 or,

Â or $8 basically pays over and over and over again.

Â Every year it pays $8 of interest on the 100 million, excuse, 8, 8 million.

Â Dollars of interest on that $100 million of debt.

Â And that is simply calculated as the principal that is the $100 million of

Â debt, multiplied by 8%, that gives me an $8 million annual payment, and would, just

Â to make this very simple because it's not really important for where we're going.

Â Are we going to assume that the company is going to be paying these forever?

Â It pays over and over and over, every year it pays $8 million.

Â Now, compare column two and column three.

Â We have two companies with the same revenue,

Â two companies with the same costs, two companies with the same EBIT.

Â EBIT is Earnings Before Interest and Taxes, and

Â that basically is revenues minus cost.

Â And as you see, both companies have the same, $100 million.

Â And here comes the difference.

Â The first company has no debt and that means that it pays actually no interest,

Â therefore the earnings before taxes, after interest but

Â before taxes, are 100 million.

Â Now the other company does pay interest and, as we said before,

Â it pays eight million every year which means that, in this particular year,

Â it's going to pay eight million and after you take that into account,

Â the earnings after interest but before taxes are 92 million.

Â Now, notice what happens in the next line.

Â Because the companies have, after interest but

Â before taxes, they have different profits, one has 100 million and the other 92.

Â And because we calculate the taxes

Â on 35% on whatever profits each company actually had.

Â Well, the first company's going to pay 35% of 100 million,

Â is going to pay 65 million, but the second company is going

Â to pay 35% on 92 million, and that is 32.2.

Â And, therefore, the net income of the company that the total the, the profit,

Â the bottom line of the company is going to be 59.8.

Â Now, notice that one company seems to be more profitable than other than the other.

Â And that is the company that pays no interest seems to be more profitable.

Â Well, that, that's actually not the right way to think about it.

Â For now, the only thing that matters is that one company pays

Â $35 million in taxes.

Â And the other pays $32.2 million in taxes.

Â So notice that when you compare Company 1 with Company 2, one pays 35 million,

Â the other pays 32.2, and therefore there's a 2.8 million difference.

Â That is a tax saving that the second company gets.

Â For having debt, and therefore for paying interest.

Â And, and that $2.8 million, some people refer to that as a tax shield.

Â That is, because I have a debt, because I have interest,

Â I have to pay interest, I do not get to pay $2.8 million in taxes.

Â That a company just like me, that would have no debt, has to actually pay.

Â So that difference between 35 million and 32.2.

Â 2.8 million is what some people would refer to as a tax, shelter.

Â Now, notice the following.

Â I am paying $8 million in interest, but

Â I get a tax break relative to a company that pays no interest of 2.8.

Â So if I subtract 2.8 from eight, I get 5.2.

Â That is what some people would say.

Â That is what I'm effectively paying in terms of interest,

Â because I am actually paying 8 million, but I'm getting a tax break of 2.8.

Â So at the end of the day, when I aggregate these things, I'm paying 5.2.

Â As if I'm paying 5.2, relative to the 100 million of

Â debt that I have in my capital structure, then I'm effectively paying 5.2%.

Â Or after tax, I'm paying 5.2%.

Â So keep in mind this number.

Â I'm paying 8 million dollars in interest, I get a tax break of 2.8.

Â I'm effectively paying 5.2 million dollars after the tax break which means that,

Â yes my interest rate is 8% but after the tax break is actually 5.2%.

Â Now there's another way of looking at that.

Â And the other way of looking at that,

Â remember what we defined before, as the, as the after tax cost of debt.

Â It was one minus TC multiplied by RD.

Â Well, one minus TC is one minus 0.35.

Â 0.35 is the corporate tax rate.

Â 8% is the interest on the debt.

Â And if you calculate 1 minus 0.35, multiplied by8%, guess what you get?

Â You get exactly 5.2%,

Â that is why we call 1 minus tc times RD the after-tax cost of debt.

Â So if you compare the 5.2% we calculated by multiplying 1 minus 0.35 times 8%,

Â that's exactly the same number we had arrived before,

Â by looking at how much we're effectively paying in terms of cash,

Â 5.2 million, relative to the 100 million that we have in terms of debt.

Â So bottom line is, when you pay interest, you get a tax break.

Â That tax break actually saves taxes that you have to pay, reduces the cost of debt.

Â And so there's a before tax and an after tax cost of debt.

Â In terms of our notation RD is the before tax cost of debt.

Â And one minus the C multiplied by RD is the after tax cost of debt.

Â That's why in the, if you if you remember the notation that we used before,

Â in the first term that was associated to debt, there was a 1 minus tc, but

Â in the second term associated to equity there was no 1 minus tc.

Â The reason is you get no tax break when you pay dividends,

Â you only get a tax break when you pay interest on, on the debt.

Â We'll get back to this, but for now, keep in mind.

Â Interest actually gives you a tax break, a tax break reduces the cost of debt.

Â And so there's a before tax and an after tax.

Â Cost of debt.

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