Tax Benefits of Debt Financing and Financial Restructuring for Positive ROI

1
Case Scenario: The Angel Investor

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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.