Question

If taxes rate decreases (for example, from 40% to 20%). Given the following four statements:

I. The benefit of tax shield created by debt decreases.

II. The cost of debt (financial distress and bankruptcy cost) increases.

III. When taxes rate is 20%, the cost of equity will increase with leverage but at a slower rate compared to when tax rate is 40%.

IV. For the same firm, the optimal capital structure will have a lower leverage ratio when tax rate decreases.

I and II are correct
		All statements are correct
		I, III, and IV are correct
		Only III and IV are correct
		Only II and III are correct.

Answer 1

I, III, and IV are correct

1 is true. If the tax rate decreases, the tax shield will also decrease.

2: Cost of debt is unaffected.

3 is true. HIgehr the tax rate higher the cost of equity with leverage.

4 is true. At a lower tax rate the tax advantage is lesser and so the firm will have lesser debt.