Question

If Congress increased the personal tax rate on interest, dividends, and capital gains but simultaneously reduced the rate on corporate income, what effect would this have on the average company’s capital structure?

Answer 1

Increase in the personal tax rate on interest, dividends, and capital gains will not have any impact on the corporate's capital structure.

Reduction in corporate income taxes will impact the company's capital structure. It will have the following impact on the company's capital structure:

1. Corporate tax rate will go down, hence corporate profits will go up. Internal accruals will increase and hence proportion of equity in capital structure will go up with time.
2. Post tax cost of debt [Kd x (1 - T)] will now be relatively higher than before. This will also go a long way in bridging the gap between equity and debt as cost of financing through debt is lower than that through equity. This will also marginally increase the proportion of equity in capital structure.
3. Because of increase in post tax cost of debt and proportion of equity in capital structure, Weighted average cost of capital of the companies will go up.