Question

In Australia, the tax on dividends and capital gains is15%, the corporate tax rate is 30% and the individual tax on interestpayments is 50%.

1.

A) Considering personal and corporate taxes, does debt has a nettax advantage in Australia? Assuming that other than tax thereare no advantages or disadvantages of debt, what is the optimalleverage ratio (0% to 100%) for companies in Australia?

B)Suppose the new government plans to increase the tax on divi-dends from 15% to 30%? Should the amount of leverage used byAustralian companies increase or decrease? What is the optimalleverage ratio under new tax regime?

Answer 1

1. There is no nettax advantage on interest payments.

Assume the interest payments is $ 100 ; then the company will save a $ 30 in Corporate taxes. However the bankers or deposit holders ( from whom the loan is financed ) will pay $ 50 in tax on the interest payments of $ 100.

So the company saves $ 30 but the inividual pays $ 50 . As such there is no savings . Its an outlay of of 20%.

The other option is finance this by equity. Then there is no interest payment & no corresponding tax saving. However the individual who receives the dividend will pay only 15 % tax . ( As against 20 % in case of interest).

IF the compnay pays $ 70 in interest then it will save $ 21 in tax & the individual who receivs will pay $ 35 in tax . So the net tax will be 14 % . So this in the optimal level of debt interest.

2. IF the tax on dividends go to 30% then the Leverage should increase .

IN the above example if the interest payments go to $ 150 then there will be corporate tax savings of $ 45 & the individual will pay $ 75 in tax . So the net tax will be 30 % which will be euqal to dividend tax.

So the leverage should go up by 50 % .