Question

In: Finance

Which one of the following statements concerning financial leverage is correct?   a)Financial leverage increases profits and...

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.

Solutions

Expert Solution

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, Rd associated with it and Rd*D is the taxable income or interests owed by company towards its lender. Tax shields depends on the prevailing corporate taxes Hence, if tc is the prevailing corporate tax rate , the after tax cost of Debt becomes (1-tc)*Rd. So (1-tc)*Rd*D is the is the new interests that the company owes and the reduction of tc*Rd*D from the previous interest owed is the amount of tax shield. So Financial leverage/Debts creates tax shied of value tc*Rd*D where tc is the corporate tax rate, Rd is the cost of debt and D is the amount of financial leverage.

Option D is correct


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