Corporate Finance - Tax and Bankruptcy Costs

Tax Effect on the Cost of Capital
With respect to taxes, it is important to keep in mind that interest payments on debt can be deducted as expenses and thus reduce overall taxes. However, a company cannot report dividends as an expense, so dividends have no effect on the taxes of a company. This is important for a company to keep in mind when determining and making changes to its capital structure.

Bankruptcy Effect on the Cost of Capital
Bankruptcy costs can also significantly affect a company's cost of capital. When a company invests in debt, the company is required to service the debt by making required interest payments. Interest payments alter a company's earnings as well as cash flow. For each company there is an optimal capital structure, including a percentage of debt and equity, a balance between the tax benefits of the debt and the equity. As a company continues to increase its debt over the amount stated by the optimal capital structure, the cost to finance the debt becomes higher as the debt is now riskier to the lender. The risk of bankruptcy increases with the increased debt load. Since the cost of debt becomes higher, the WACC is thus affected. With the addition of debt, the WACC will at first fall as the benefits are realized, but once the optimal capital structure is reached and then surpassed, the increased debt load will then cause the WACC to increase significantly.
 

The MM Capital Structure vs. The Tradeoff Theory of Leverage


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