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Essay text:
However
it is dependant on the debt-equity ratio (capital structure) of the firm as well as the
dividend policy (payout policy) of the firm.
If the firm has adequate unsheltered taxable income, increasing debt increases
interest and lowers taxes. This is because interest payable is deducted from EBIT
before taxes are calculated. The amount by which interest expense reduces taxes is
called the Interest Tax Shield (ITS), where
ITS = Interest x corporate tax rate = I x TC
As taxes reduce, the cash flows available to the shareholders and debtholders
increase. So having more debt on the capital structure increases cash flows to the
shareholders and debtholders in the current period, but increasing debt could be a
suboptimal strategy for a firm in the long run because of higher expected distress
costs associated with more debt...
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