The interest tax shield is a key reason why:
A)the required rate of return on assets rises when debt is added to the capital structure.
B)the value of an unlevered firm is equal to the value of a levered firm.
C)the net cost of debt to a firm is generally less than the cost of equity.
D)the cost of debt is equal to the cost of equity for a levered firm.
E)firms prefer equity financing over debt financing.

Question

Quizplus · Accepted Answer

The interest tax shield refers to the tax savings a company receives by deducting interest expenses from its taxable income. This means that the net cost of debt to a firm (which takes into account the tax savings from the interest tax shield) is generally less than the cost of equity. This makes debt financing an attractive option for some firms, as it can lower their overall cost of capital. Choice A is incorrect because the required rate of return on assets is independent of the capital structure. Choice B is incorrect because the value of a levered firm is typically greater than that of an unlevered firm due to the tax benefits of debt financing. Choice D is incorrect because the cost of debt is typically lower than the cost of equity for a levered firm, as explained in choice C. Choice E is incorrect because the interest tax shield makes debt financing an attractive option for some firms.

The Interest Tax Shield Is a Key Reason Why