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3. Since interest payments are fully deductible for tax purposes should a firm’s capital structure be...

3. Since interest payments are fully deductible for tax purposes should a firm’s capital structure be all debt financed. Why & why not?

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Answer #1

No doubt that debt is cheaper source of finance and interest payments are fully deductible for tax purposes.

However, it is not recommended to have all debt financed capital structure.

Higher the leverage, riskier the firm which will increase the debt cost for firm.

All debt financed firm will default on interest payments if firm is incurring loss in its initial years of operations or if the profit reverses of the firm are less. This could force closure of business if lenders force sell of assets in case of secured lenders. There is high probability that all debt financed firm will go insolvent.

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