Question

Discuss the importance of taxes and the risk of financial distress in determining capital structure?

Answer 1

In determining debt for the capital structure, two important factors have to be taken into consideration, taxes and risk of financial distress.

Debt has interest tax benefit ie interest payments are paid before the taxes are paid and hence the firm could have a lower tax outgo while using debt. This reduces the overall cost of capital while using debt in the capital structure.

However, at the same time, debt beyond a certain level also increases the financial leverage and the risk of financial distress. This causes larger risk premium on the debt and hence higher debt costs increasing the cost of capital.

Thus a firm has to choose an optimal amount of debt in the capital structure to balance the taxes on one side and the risk of financial distress.