IAI Actuarial Core Principles · Business Finance · Personal and corporate taxation
Which factor most directly limits the benefit of increasing debt to exploit the interest tax shield?
The rising costs of financial distress limit the benefit. As gearing increases, the chance and cost of insolvency grow, which eventually outweigh the extra interest tax shield, so the optimal capital structure contains some debt but not the maximum possible.
- ADividends being paid from after-tax profits
- BThe costs of financial distress rising as gearing increasesCorrect
- CInterest payments being deductible
- DThe corporate tax rate being positive
- Equity investors requiring any return at all
Explanation
Trade-off theory says higher gearing raises expected bankruptcy and distress costs, offsetting the tax shield at some point, giving an optimal gearing level. The other options either support the shield or are not limiting factors.
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