prob_set_07ans - University of California Davis Department...

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University of California, Davis Department of Economics ECONOMICS 131 L. Jay Helms Answers to Problem Set #7 1. The Corporation Income Tax and Corporate Finance a. Interest payments on corporate debt are deductible, meaning that the return to debt is excluded from the corporation tax base. In contrast, neither dividends nor retained earnings are deductible, meaning that the returns to equity are fully taxed. b. There is a clear incentive to raise capital by borrowing rather than by selling stock. The resultant increase in corporation debt is likely to increase the probability of bankruptcy. c. If a firm retains $1 in earnings rather than paying it out as a dividend, the increased value of the firm should be reflected as a $1 increase in the value of the firm’s stock. Taxable stockholders would prefer to have the capital gain (which results from retained earnings) rather than to receive current dividends, because dividends are immediately taxable while capital gains are taxed only when the stock is sold, and then at rates which may be preferential.
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