Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If there were no personal taxes on capital gains, which of the following investors would not care how the money was channeled? (The corporate tax rate is 35%)
A) Investors paying personal tax of 17.5%
B) Investors paying personal tax of 35%
C) Investors paying personal tax of 53%
D) None of the above

Question

Quizplus · Accepted Answer

Investors paying personal tax of 35% would not care how the money was channeled because the corporate tax rate of 35% would offset their personal tax rate, resulting in no difference in their after-tax return whether the money was directed towards debt interest or capital gains. For investors paying a lower personal tax rate (Option A) they would prefer capital gains since it would be taxed at a lower rate than debt interest. For investors paying a higher personal tax rate (Option C), they would prefer debt interest because it would be taxed at a lower rate than capital gains.

Suppose That a Company Can Direct $1 to Either Debt