Question

Business organizations raise capital from various sources including debt, equity or a combination of both.

Discussion Question:

1. Do you agree or disagree with the following statement? Defend your response. “Our tax system and tax systems of many countries favor debt financing over equity financing.”

2. How does the addition of debt to capital structure affect the risk to equity holders and the cost of equity?

Answer 1

1. I agree with the statement that the tax system of most countries favours debt financing over equity. This is because in most of the countries interest is tax deductible as an expense in the income statement while dividend is considered and appropriation of profit. Claiming interest as a tax deductible expense reduces the Tax amount payable by the business and this reduces the cost of debt financing. Equity financing on the other hand has a much higher cost and so it is correct to say that tax systems favour debt financing.

2. Addition of debt increases the risk of the business firstly because there is a fixed interest burden which has to be paid irrespective of whether the business has a profit or loss. Moreover the amount of debt is a liability and has to be repaid at maturity. This increases the risk of bankruptcy for equity shareholders because the company has to pay back the liabilities irrespective of whether it has additional funds or not.