Question

Let Tb = personal tax rate on interest received, Ts = personal tax rate on dividends, and Tc = corporate tax rate on earnings. If (1 – Tb) is greater than the product of (1 – Tc) and (1 – Ts), Select one:

a. the corporation has incentive to use equity.

b. the corporation must pay higher interest on its debt.

c. the shareholder would not buy equity.

d. the corporation has incentive to increase financial leverage.

e. the corporation will not be able to invest in all its positive net present value projects.

Answer 1

The correct answer is the option d. the corporation has incentive to increase financial leverage.

(1 – Tb) is greater than the product of (1 – Tc) and (1 – Ts)

i.e (1 – Tb) > (1 – Tc)(1 – Ts)

Hence, 1 > (1 – Tc)(1 – Ts) / (1 – Tb)

Hence, 1 - (1 – Tc)(1 – Ts) / (1 – Tb) > 0

The LHS is an expression for Effective Tax Advantage of Debt. Therefore, in terms of after-tax cash flows,
debt is more favorable than equity. Hence the correct answer is the option d. the corporation has incentive to increase financial leverage.