Question

Assume the current corporate income tax rate is 0%. If the rate were increased to 15%, how would this impact the after-tax cost of debt? All else equal, would firms be more or less likely to issue debt as opposed to equity?

Answer 1

When the income tax rate increased to 15%, the a debenture is a senior secured debt will decrease because of the tax advantage of debt interest. The tax advantage means, the interest paid by the company towards the debt is deductible in the Profit & Loss account of the company. This will reduce the taxable profits of the company and thereby tax liability.

All else equal, the firms would issue debt more because the cost of debt is less since it gives tax advantage to the company. There is no tax advantage for the dividends paid and hence the cost of equity is high compared to debt capital.