Which of the following statements is correct? A) Corporate taxation can generate tax savings to the...

Which of the following statements is correct?
A) Corporate taxation can generate tax savings to the unlevered firm. Therefore, the optimal capital structure should be financed by equity entirely.
B) Corporate taxation can generate tax saving to the levered firm. Therefore, the optimal capital structure should exclude debt to completely offset the tax liability.
C) Corporate taxation can generate tax saving to the levered firm. Therefore, the optimal capital structure includes enough debt to completely offset the tax liability.
D) None of the above.

Expert Solution

Answer : C) Corporate taxation can generate tax saving to the levered firm. Therefore, the optimal capital structure includes enough debt to completely offset the tax liability.

The benefit of leverage in the form of tax saving is available to the levered firm. Levered firm is a company that has debt in its capital structure. The tax advantage is available for the debt of the company. Because the interest expenses paid for the debt is eligible for tax shield and thus corporate tax can be reduced. Such benefit can be availed only if there is debt in the company's capital structure. So an optimal capital structure must include enough debt.

A) Corporate taxation cannot generate tax savings to the unlevered firm, since there is no debt in an unlevered firm. The statement (A) is incorrect.

B) Corporate taxation can generate tax saving to the levered firm. But the optimal capital structure should not exclude debt to avail tax advantage. So the statement (B) is incorrect.

D) This option also is wrong.

jeff jeffy answered 1 year ago

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