Question

The benefits of debt financing over equity financing are likely to be highest in which of the following situations?

• A. High marginal tax rates and low non-interest tax benefits
• B. Low marginal tax rates and low non-interest tax benefits
• C. High marginal tax rates and high non-interest tax benefits
• D. Low marginal tax rates and high non-interest tax benefits

Answer 1

Answer: (A)

High marginal tax rates and low non-interest tax benefits

A marginal tax rate is the tax rate incurred on each additional dollar of income. The marginal tax rate for an individual will increase as income rises. This method of taxation aims to fairly tax individuals based upon their earnings, with low-income earners being taxed at a lower rate than higher income earners.

Debenture holders are to be paid despite of the fact whether company earns a profit or not but this is not in the case of equity shareholders. so if there is high marginal tax then there will be less financial risk. Therefore, the benefits of debt financing over equity financing is highest.