Question

When discussing financing strategies, the benefits and costs of using debt should be of primary concern. The most important benefit from including debt in a firm's capital structure stems from the fact that firms can deduct interest payments for tax purposes but cannot deduct dividend payments. This makes it less costly to distribute cash to security holders through interest payments than through dividends.

The total dollar amount of interest paid each year and, therefore, the amount that will be deducted from the firm's taxable income is:

D × k_Debt

·        This will result in a reduction in taxes paid (the interest tax shield) of

D × k_Debt × t

where t is the firm's marginal tax rate that applies to the interest expense deduction.

What are some other benefits of using debt and why are these effective?

Answer 1

Benefits	Explanation
Retain control.	When you agree to debt financing from a lending institution, the lender has no say in how you manage your company. You make all the decisions. The business relationship ends once you have repaid the loan in full.
Easier planning	You know well in advance exactly how much principal and interest you will pay back each month. This makes it easier to budget and make financial plans.
Low cost and Effective way of financing	If ROI is greater than the cost of of debt, then it is beneficial to have debt in the company as it will create wealth to existing shareholders. However, if ROI is less than cost of debt then debt is not beneficial