Question

The tax deductibility of interest payments lowers the after-tax cost of debt in the firm’s capital structure. If adding debt to the capital structure lowers the firm’s WACC why do firms not seek to have 100% debt in their capital structure?

Answer 1

Yes this is true that the tax deductibility of interest payment lowers the after tax cost of debt in firm's capital structure. But even then the firms donot seek to have 100% debt in the capital structure.

Debt is cheaper than equity because both of them have different corporate tax treatment. In Profit & Loss Account, interest is subtracted before the tax is calculated this, companies get tax relief on interest.

However, dividends are subtracted after the tax is calculated and thus, companies don't get any tax relief. But too much debt increases financial risk for the stakeholders and also the return on equity.

Therefore, companies have to find an optimal point where the marginal benefit of debt equals the marginal costs.