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IAI Actuarial Core Principles · Business Finance · Personal and corporate taxation

Which of the following is a recognised reason why a company should not borrow without limit to maximise its tax shield?

Higher gearing raises the expected costs of financial distress, such as bankruptcy and loss of customers, and at high debt levels these outweigh the tax shield benefit. This trade-off implies an optimal level of debt rather than unlimited borrowing.

  1. AInterest payments become non-deductible once the debt exceeds the equity
  2. BHigher gearing increases the expected costs of financial distress, which offset the tax benefit at high levels of debtCorrect
  3. CDividends become taxable in the hands of the company when gearing rises
  4. DDebt always carries a lower pre-tax cost than equity, so no limit is needed
  5. The tax rate on companies rises automatically as gearing rises

Explanation

The trade-off theory says the tax shield benefit is offset at high gearing by rising financial distress and bankruptcy costs, giving an optimal capital structure. The other options state tax rules that do not exist or are not the reason.

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