Question

Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure?
A. The costs that would be incurred in the event of bankruptcy increase.
B. The proportion of fixed costs (operating leverage) increases.
C. The corporate tax rate increases.
D. Its sales become less stable over time

Answer 1

Answer: Option (c) is correct.

Explanation:

Correct Option: The corporate tax rate increases.

If there is an increase in the corporate tax rate then this will induce the firms to increase the amount of their debt. This is due to the fact that the firms with more debt are going to pay less tax because of the large interest expense. Due to large interest expenses, their income before tax reduces.

Hence, large corporate taxes encourage firms to increase the amount of debt. Therefore, the firms with no debt pays higher taxes than the firms with higher amount of debt.