Tax benefits of debt

Tax benefits of debt

In the context of corporate finance, the Tax Benefits of Debt or Tax Advantage of Debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt than with equity. Under a majority of taxation systems around the world, and until recently under the U.S. tax system firms are taxed on their profits and also individuals are taxed on their personal income. A firm that earns $100 dollars in profits in the U.S. for example, would have to pay around $30 dollars in taxes. If it then distributes these profits to its owners as dividends, then the owners in turn pay taxes on this income. Say $20 on the $70 dollars of dividends. So that $100 dollars of profits turned into $50 dollars of investor income.

If, instead the firm finances with debt, then, assuming the firm owes $100 dollars of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say $30 dollars. This implies for $100 dollars of profits before interest, investors got $70 dollars. [ [http://faculty.fuqua.duke.edu/~jgraham/HowBigFinalJF.pdf Graham, John, "How big are the Tax Benefits of Debt" The Journal of Finance, 2000.] ]

See also

* Trade-Off Theory

* capital structure

*Dividend Taxes

References


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