CORPORATE TAXES - (A) Given the following tax rates: 50% personal and 33% corpor

Question

CORPORATE TAXES -

(A) Given the following tax rates: 50% personal and 33% corporate, and assuming the firm in question compensates it stockholders entirely through capital gains that will not be realized for the foreseeable future, should this firm do its next finance with debt or equity (based solely on taxes)? Why?

CORPORATE TAXES AND BANKRUPTCY COSTS -

(B) In Slobovia, an obscure European country, dividends and interest are given the same tax treatment: they are both deductible at the corporate level and both are taxes as income at the investor's level. All else the same, where would you expect more corporate bankruptcies, in Slobovia or in the U.S.? Explain.

Explanation / Answer

A) The firm should finance by way of equity in this case. This is because if the financing is done by debt, the firm will pay out interest to the stakeholders. This will be taxed at 50%, whereas the company will save only 33% by way of tax saving on interest. Hence it is better to issue equity since the dividends are not paid out and taxed in the hands of the shareholders at 50% rate.

b) I expect more bankruptcies in the US. This is because the US firms are more inclined to take on debt due to tax saving on interest payments whereas in Slobovia, there is no particular preference towards debt since both dividend and interest are deductible.

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