Tax Benefits of Debt Financing and Financial Restructuring for Positive ROI

This article discusses the tax benefits of debt financing and how financial restructuring can lead to a positive return on investment (ROI). It includes a calculation of after tax Weighted average cost of capital and evaluation of investment and comparison with the return on investment. The article also explores the cases when a company requires less debt or more debt capital.

1
Case Scenario: The Angel Investor

2
Tax Benefits of Debt Financing
The firms tend to incorporate larger use of debt for financing in comparison to equity for
gaining tax advantage of debt. This is largely because the interest that is paid on borrowed
money is tax deductible. The interest that is paid on the debt obligations can be deducted as a
business expense as long as the loan taken is used for carrying out the business activities. On the
contrary, the dividends that are paid to the equity holders are not tax-deductible and do not
provide any significant advantage to the company in savings of their tax. As such, it can be said
that use of debt financing enables a firm to realize tax savings that is not gained by a firm during
equity financing (Madura, 2014).
Calculation of after tax Weighted average cost of capital
Formula of Weighted average cost of capital: Cost of Debt (After tax) * Percentage of debt
capital + Cost of Equity * Percentage of equity capital (Firer, 2012)
Given Information
Cost of Debt (Before tax)
10.00
%
Cost of Equity
15.00
%
Percentage of debt capital
60.00
%
Percentage of Equity capital
40.00
%
Tax rate
35.00
%
Cost of Debt (After tax) 6.50%
Calculation of Weighted Average cost of capital
Capital Weight
s
Cost of
Capital
Weighted cost
of capital
Debt Capital 60% 6.50% 3.90%
Equity Capital 40% 15.00% 6.00%
9.90%
Evaluation of investment and comparison with the return on investment
As an Angle Investor, company must choose financing option that has lower cost of
capital (AT WACC) in comparison to the return on equity. The return on investment of the
company is 8% which fall short of calculated after tax weighted average cost of capital of 9.90%.
It means company is paying more for cost of capital in comparison to what it is earning (ROI).
So, cost of capital must be below 8% (ROI) in order to make it viable investment as an Angel
Investor.

3
Financial Restructuring
In order to have positive return on investment ie AT WACC of below 8% there is need to
perform financial restructuring. To have lower AT WACC there is need to select the capital that
has lower cost of finance in comparison to return on investment. As debt capital has lower cost
of capital, it is required to increase the percentage of debt capital from 60 % to 90% and lower
the percentage of equity capital from 40% to 10%. After the change in percentage of both the
capitals (Debt and Equity) the new AT WACC is as under:
New Information
Cost of Debt (Before tax) 10.00%
Cost of Equity 15.00%
Percentage of debt capital 90.00%
Percentage of Equity capital 10.00%
Tax rate 35.00%
Cost of Debt (After tax) 6.50%
Calculation of Weighted Average cost of capital using the New
information
Capital Weight
s
Cost of
Capital
Weighted cost
of capital
Debt Capital 90% 6.50% 5.85%
Equity Capital 10% 15.00% 1.50%
7.35%
In this case the AT WACC is lower than the return on investment which means company
will have pay to pay lower cost on capital as compare to what it is earning. So it is a viable
investment and provides positive ROI (Davies and Crawford, 2011).
Debt Capital versus Equity Capital
 Case when company requires less debt: As debt capital creates a charge on the assets of
company and there is required to settle the interest every period irrespective of reasonable
profits. It means it create a charge on profit of the company. On the other hand equity
capital does not create any charge on profits of the company and this capital is also
referred as owner’s capital. This is the reason why company requires more equity capital
as compare to debt capital.
 Case when company more debt capital: When the cost of debt is highly lower than the
cost of equity and it is easy to have debt finance than company should go for maximum
debt financing as compare to equity financing. It is irrespective of charge on assets that
will be created due to debt financing if loan is not repaid (Damodaran, 2011).

4
References
Damodaran, A, (2011). Applied corporate finance. John Wiley & sons.
Davies, T. & Crawford, I., (2011). Business accounting and finance. Pearson.
Firer, C. (2012). Fundamentals of Corporate Finance. Berkshire. McGraw-Hill.
Madura, J. (2014). Financial Markets and Institutions. Cengage Learning.