Question

a. What is the relative tax advantage of corporate debt if the corporate tax rate is Tc = .39, the personal tax rate is Tp = .25, but all equity income is received as capital gains and escapes tax entirely (TpE = 0)? (Round your answer to 2 decimal places.)

Relative tax advantage

b. How does the relative tax advantage change if the company decides to pay out all equity income as cash dividends that are taxed at 15%? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Relative tax advantage

Answer 1

The relative tax advantage of debt means financing through issuing if debt is cheaper than equity as it reduces the taxes by increasing the expense ( interest)

Relative tax advantage of debt = ( 1 - Tp ) / ( 1 - TpE) ( 1 - Tc)

Tc = coporate tax rate

TpE =capital gain tax rate

Tp = personal tax rate

= ( 1 - 0.25 ) / ( 1 - 0 ) ( 1 - 0.39)

= 0.75 / 0.61

= 1.23

Relative tax advantage of debt = ( 1 - Tp ) / ( 1 - TpE) ( 1 - Tc)

    = ( 1 - 0.25 ) / ( 1 - 0.15 ) ( 1 - 0.39)

= 1.45

Here TpE = Tax rate for dividends