Question

Issuing debt will be the most beneficial in terms of increasing firm value to which of the following firms?
An unprofitable firm in a low tax bracket
A highly profitable firm in a low tax bracket
An unprofitable firm in a high tax bracket
A highly profitable firm in a high tax bracket
A firm which pays no taxes

Answer 1

Option (D): A highly profitable firm in a high tax bracket

Explanation:

~ The inclusion of debt in the capital structure will be most benefical to a firm which is highly profitable and is having a high tax bracket.

~ The reason is that the interest paid on the debt is a tax deductible expense which increases the value of firm by the tax savings made by the inclusion of debt.

~ Higher the tax rate, higher will be the tax savings on intetest paid on debt.

~ Hence, this situation will be most beneficial only of firm is a profitable firm.