8. Your firm has had steady earnings for many years but it has resisted paying d

Question

8. Your firm has had steady earnings for many years but it has resisted paying dividends. It typically uses its earnings to finance replacement of its worn out assets, thus saving the cost of borrowing money to do this. Its stock price has not risen much in recent years. The Drucker-educated consultant tells the CEO to start paying a modest dividend out of earning. "The borrowing costs you will incur by occasionally having to raise money with debt will be outweighed by a subtle benefit." What subtle benefit is the consultant referring to?

Explanation / Answer

Answer: This subtle benefit is tax relief you get on taking debt which is not avilable if you are financing things through equity

So, the interest you pay in debt is not counted in the income and is being considered as expense

example: suppose you paid $2000 as interest on the loan taken of $10000. yoour income during the year was $20000 and tax rate is 35%.

Now because you have borrowed this 2000 will be deducted from your income and then tax will be applied

Amount saved because of this $2000*35% = $700

this is how you get benefit on raising mioney through debt which is not the case on taking equity

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