Question

Which one of the following statements concerning financial leverage is correct?  

		a)Financial leverage increases profits and decreases losses.
		b)Financial leverage has no effect on a firm's return on equity.
		c)Increasing financial leverage decrease a firm’s business risk
		d)Financial leverage creates tax shield.

Answer 1

Option D - Financial leverage creates tax shield is correct

Explanation - Financial leverage are debts taken by companies to finance their businesses whereas tax shield results in the reduction of interests that are owed by companies on the debt. Suppose D is the value of Debt of a company. Every debt has a cost of Debt, R_d associated with it and R_d*D is the taxable income or interests owed by company towards its lender. Tax shields depends on the prevailing corporate taxes Hence, if t_c is the prevailing corporate tax rate , the after tax cost of Debt becomes (1-t_c)*R_d. So (1-t_c)*R_d*D is the is the new interests that the company owes and the reduction of t_c*R_d*D from the previous interest owed is the amount of tax shield. So Financial leverage/Debts creates tax shied of value t_c*R_d*D where t_c is the corporate tax rate, R_d is the cost of debt and D is the amount of financial leverage.

Option D is correct