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

Interest is the return what firms have to give on bonds whereas for equity it is dividend. The Interest expense is an expense allowed for tax purpose whereas dividend is not an expense allowed for tax purpose.

Thus when corporate tax rate increases, it decreases the tax laibility to the extend of 15% on interest amount which in turn reduces the cost of debt.

Therefore tax rate increase creates a tax benefit on the Interest amount for the firm and so cost of debt becomes less compared to cost of equity.