If the IRS lowers the tax rate applicable to firms in a particular category, the optimal debt ratio for that category will ________.
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A. B. C. D.C
If the tax rate is lower, the tax-deductibility of the interest payments on debt becomes less attractive. The after-tax cost of debt rises, lowering the optimal debt ratio.
In order to determine the effect of a lower tax rate on the optimal debt ratio for firms in a particular category, we need to understand the relationship between taxes and debt.
When a firm borrows money and incurs interest expenses, it can deduct those interest expenses from its taxable income. This deduction reduces the firm's taxable income, which in turn reduces the amount of taxes the firm has to pay. As a result, the after-tax cost of debt is lower than the pre-tax cost of debt. This tax advantage makes debt financing more attractive for firms.
The optimal debt ratio refers to the level of debt that maximizes a firm's value or minimizes its cost of capital. It is determined by weighing the benefits of the tax advantage against the costs of financial distress, bankruptcy, and agency conflicts associated with high levels of debt.
Now, if the IRS (Internal Revenue Service) lowers the tax rate applicable to firms in a particular category, it means that the tax advantage associated with debt financing will be reduced. In other words, the tax shield provided by interest expense deductions will be less valuable.
Given this information, we can conclude that the optimal debt ratio for firms in that particular category will decrease (Option C). When the tax advantage of debt financing diminishes, firms have less incentive to take on higher levels of debt. As a result, they are likely to reduce their debt ratios to maintain an optimal balance between the benefits and costs of debt.
Therefore, a lower tax rate will generally lead to a decrease in the optimal debt ratio for firms in a particular category.