Let Tb = personal tax rate on interest received, Ts = personal tax rate on divid

Question

Let Tb = personal tax rate on interest received, Ts = personal tax rate on dividends, and Tc = corporate tax rate on earnings. If (1 – Tb) is greater than the product of (1 – Tc) and (1 – Ts), Select one:

a. the corporation has incentive to use equity.

b. the corporation must pay higher interest on its debt.

c. the shareholder would not buy equity.

d. the corporation has incentive to increase financial leverage.

e. the corporation will not be able to invest in all its positive net present value projects.

Explanation / Answer

If (1 – Tb) is greater than the product of (1 – Tc) and (1 – Ts) , thenthere is no gain from debt, the positive effect of corporate tax deductibility is offset by large personal tax on bond income. When this occurs, the bond holders demand higher interest on before tax basis, thus it make equity cheaper.

Thus ans a. the corporation has incentive to use equity.

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