The benefits of debt financing over equity financing are likely to be highest in which of the following situations ?
High marginal tax rates and low non-interest tax benefits
The main tax benefit of debt over equity is the interest tax shield: interest is a deductible expense, so each rupee of interest saves tax equal to the marginal tax rate.
The higher the firm's marginal tax rate, the larger the saving from each rupee of interest, so high marginal tax rates raise the benefit of debt financing.
DeAngelo and Masulis (1980) showed that non-interest (non-debt) tax shields such as depreciation, investment allowances and tax credits substitute for interest deductions. A firm that already has large non-interest tax benefits may not have enough taxable income left to use its interest deductions fully, so the benefit of debt falls.
The advantage of debt is therefore greatest when the marginal tax rate is high and non-interest tax benefits are low; a low tax rate or high non-interest tax benefits weaken it.
Hence, High marginal tax rates and low non-interest tax benefits.
Similar Questions
Match the items of List - I with the items of List - II and find out the correct matching.
List - I List - II (Formulae) (Type of leverages) (a) \(\frac{\text{Contribution}}{\text{EBIT}}\) (i) Financial leverage (b) \(\frac{\text{EBIT}}{\text{Earnings before Tax (EBT)}}\) (ii) Super – leverage (c) \(\frac{\text{Contribution}}{\text{EBT}}\) (iii) Operating leverage Codes :
(a) (b) (c)
On the basis of the following information, what will be the EBIT corresponding to financial indifference point ?
Total capital outlay ₹ 60,00,000
Financing Plans
(a) 100% Equity @ ₹ 10/- per share
(b) Debt – equity ratio 2 : 1
Rate of interest 18% p.a., corporate tax rate 40%
Combined leverage is calculated as :
Financial Leverage is measured by :
The term ‘capital structure’ implies :
The degree of super-leverage would be calculated by :
Assertion (A) : Arbitrage keeps the cost of capital constant despite change in the capital structure.
Reason (R) : It ensures compensating inverse change in cost of equity capital with a change in the cost of debt capital.
Codes :
The optimum capital structure of a company is planned as per considerations of
I. Profitability
II. Solvency
III. Marketability of shares
IV. Control
Codes :
A firm wants to know the Degree of Operating Leverage (DOL) with the following information :
Current level of sales : 6000 units
Break-even point sales : 4000 units
What would be the DOL ?
Statement – I : Capital structure refers to composition of long-term funds.
Statement – II : These include equity share capital, preference share capital, debentures, all debts and all reserves.
Important Questions from Capital structure
Choose the correct code for the following statements being correct or incorrect.
Statement I: Companies generally do not prefer low cost debt financing.
Statement II : Raising debts requires credit rating and payment of interest even if companies suffer losses.
- Which of the following theories of capital structure articulates that a firm borrows up to the point where the tax benefit from extra debt is exactly equal to the cost that comes from the increased probability of financial distress?
- The mean marks of $100$ students were found to be $45$. Later on it was discovered that at the time of computation two are wrongly taken as $23$ and $27$ instead of $32$ and $72$. What is the correct mean?
'That personal leverage can replace corporate leverage' is assumed by
The optimum capital structure is supported by which combination of the following ?
(i) Traditional theory
(ii) Net income theory
(iii) Pecking order theory
(iv) Net operating income theory
Choose the correct answer from the code given below:
