Answer:
Answer is explained in the explanation section below.
Explanation:
Solution:
It is perfectly natural that the loss will occur at the start. Since it is not able to pay fixed interest obligations, a preferential or equity capital increase is recommended. The debt fund will create a financial crisis in the capital structure because it will be difficult for the company to fulfil its payment obligation on the initial stage.
The composition of debt capital will contribute to a certain tax savings, but it will certainly increase the overall outflow of the fund.
For Example:
Total Capital is 1,000,000 costing of 500,00 debt and 500,000 equity and 40 % tax bracket.
Suppose total return is 10% on capital.
Earnings for the year : 1,000,000 * 10 % = 100,000
Interest obligation (assume borrowed at 12 % ) = 60,000
Profit before tax = 40,000
Tax at the rate 40% = 16,000
Earning after tax available for growth = 24,000
Total capital only consists of equities in this example.
The earnings will be same = 100,000
Less tax at the rate 40 % = 40,000
Net earnings available for future growth = 60,000
We have an extra earnings available for future growth is 36,000 (60,000 - 24,000).
Ignore tax saving 24,000 (40,000 - 16,000) Because the enterprise requires more for future growth following tax earnings at the initial stage.
So,
The business was structured to maximize the use of own resources instead of borrowing the fund.
