“The firm can’t use interest tax shields unless it has (taxable) income to shield.” What does this statement imply for debt policy? Explain briefly.
Tax shield helps a company or an individual to reduce taxable income by claiming different deductions such as charitable fund contributions, medical allowances, mortgage expenses, depreciation and amortization on assets.
A firm that borrow funds and pays interest will not gain the benefit of saving taxes if they have no taxable income. The payment of interest will add the benefit of carrying forward the losses only. A company with high debt implies that the firm may have no more taxable income.
Hence, those firms would have little tax encouragement to borrow.