Assume that the real riskless interest rate is zero and the corporate tax rate is 33 percent. IGWT Industries can borrow at the riskless interest rate. It will have an inflation-adjusted EBIT next year of $200 million. It would like to borrow $50 million today. Its only deductions will be interest payments (if any).
a. What are its interest payments, taxable income, tax payments, and income left for shareholders in a no-inflation environment?
b. Suppose there is inflation of 10 percent per year, but the real interest rate stays at zero. This means that investors now will require a sure payment of $1.10 next year for each $1.00 loaned today. Repeat part a, assuming that EBIT is affected by inflation.
c. In which environment is the inflation-adjusted income left for shareholders higher? Why?