Tax benefits allowing firms to deduct interest

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Unformatted text preview: e amount of the firm’s earnings paid in taxes, thereby making more earnings available for bondholders and stockholders. The deductibility of interest means the cost of debt, ki, to the firm is subsidized by the government. Letting kd equal the before-tax cost of debt and letting T equal the tax rate, from Chapter 11 (Equation 11.2), we have ki kd (1 T). Probability of Bankruptcy The chance that a firm will become bankrupt because of an inability to meet its obligations as they come due depends largely on its level of both business risk and financial risk. Business Risk In Chapter 11, we defined business risk as the risk to the firm of being unable to cover its operating costs. In general, the greater the firm’s operating leverage—the use of fixed operating costs—the higher its business risk. Although operating leverage is an important factor affecting business risk, two 14. Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Ec...
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