Question

1) How do cost of funds and taxes affect decisions made by investors and the firm? Please explain 2) Since interest payments are fully deductible for tax purposes should a firm’s capital structure be all debt financed? Why & why not?

Answer 1

1) Cost of funds and taxes affects decisions made by investors and the firms to a great extent. Cost of funds include the cost of acquiring the funds that is common stock, preference shares and debt. There must be an optimum mix of all kind of funds. The decision rest on the cost associated with various kind of funds. Interest is associated with debt and carries a tax benefit on it. On the other hand, there is no such tax deduction on dividends paid to shareholders. Therefore, leverage companies acquire more of debt to reduce the ultimate cost of capital to a threshold limit. In a nutshell,

• cost of Debt includes interest paid to lenders and carries a tax benefit.
• Tax benefit reduces the overall cost of capital of the company as more debts are acquired.
• Leverage company benefits from acquiring more debts but to a threshold limit.
• Dividends paid to shareholders doesn't carry any tax benefit. So, overall cost is high of unleveraged company in comparison to leveraged company.
• Thus, increase debt will reduce the overall cost of capital of a firm.

2) No, Capital Structure must not be fully debt financed as it will positively impact the cash flow statement as well as increase the liabilities side in the Balance Sheet. Increased leverage ratio such as Debt-to-Equity requires the firm to maintain the Interest Coverage ratio. At the time of liquidation, lenders comes first to receive the debt amount than to shareholders. It is possible to dilute the ownership in equities but not possible in debt. Thus, it is not possible for a firm to fully finance the Capital Structure with debt as companies are required to maintain that much Interest Coverage ratio which is not feasible in practice.