Question

In 2018 the US Federal Corporate tax rate decreased from 35% to 21%. Other taxes remained largely the same.

According to the trade-off theory, you would expect that

1. firms will increase their debt-to-equity ratio by borrowing more to finance new projects as it is now more profitable to do so.
2. firms will issue more long-term debt and less short-term debt, leaving their debt-to-equity ratio unchanged.
3. firms will reduce their debt-to-equity ratio because the tax benefits of debt financing are now lower.
4. firms will pay out more dividends as they must pay less in corporate taxes, increasing their debt-to-equity ratio.

Answer 1

option C: firms will reduce their debt-to-equity ratio because the tax benefits of debt financing are now lower.

---- Trade off theory states that a firm will adjust its debt and equity levels (capital structure) such that it balances the cost and benefit from both the source of fund and an optimum capital structure is reached. Here since the tax rate has reduced, the firms benefit of taking debt will lower due to lower interest tax shield. Hence firm will try to reduce Debt/Equity ratio.