Your friend has recently told you that the federal government effectively subsidizes the use of...

Question:

Your friend has recently told you that the federal government effectively subsidizes the use of debt financing (vs. equity financing) for corporations.

Explain what your friend means.

Capital Structure:

This question relates to a firm's capital structure, which is the strategic composition of debt and equity utilized to finance operations. Debt financing involves the issuance of loans and bonds, and equity financing involves the issuance of stock or the use of retained earnings (self-financing).

Capital structures vary widely across industries and firms. In general, a high proportion of debt-to-equity (also known as financial leverage) is considered risky. However, firms with 100% equity capital often find it difficult to generate adequate rates of return for their shareholders.

Answer and Explanation:

In determining an optimal capital structure, management must consider the tax ramification of using debt versus equity. The interest paid on debt is tax deductible, but dividends paid to stockholders are not. This means debt financing, which is generally cheaper than equity financing (due to its higher positioning in the capital stack), is even cheaper on an after-tax basis.

The tax deductibility of the interest expense is the friend's rationale for asserting that the federal government effectively subsidizes the use of debt financing (vs. equity financing) for corporations.


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Capital Structure & the Cost of Capital

from Finance 101: Principles of Finance

Chapter 15 / Lesson 1
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