Question

Which of the following would likely encourage a firm to increase the debt in its capital structure? Provide rationale for your position on each option.

a. Corporate tax rate increases

b. personal tax rate increases

c. Due to market changes, the firm's assets become less liquid

d. changes in the bankruptcy code make bankruptcy less costly to the firm

e. the firm's sales and earnings become more volatile

Answer 1

Answer: Option a is correct.
Cost of debt is calculated as after tax cost of debt, that is=(Pretax cost of debt)*(1-Tax rate)
If tax rate increases, after tax cost of debt will reduces, so firm's prefer to go for debt capital.

(b)Personal tax rate is not related to debt in its capital structure of a company.
(c)Cost of debt depends mostly on credit rating of a company and its future growth prospects, revenue generation, business the firm is into and risk profile of the firm/projects for which the firm raises debt and doesn't depend on market changes if the firm has good credit rating.
(d)Bankruptcy is filed when a firm fails to pay off the debt, no firm would expect to go for bankruptcy or become insolvent to close the operations.
(e)If the firm's sales and earnings become more volatile the future growth prospects becomes questionable and in this case most of the times the credit rating degrades, in that case cost of debt increases and it becomes difficult to raise debt capital.