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Problem Of High Gearing :
Tax Exhaustion :
After A Certain Level Of Gearing, Companies Will Discover That They Have No Tax Liability Left Against Which To Offset Interest Charges. Kd(1-t) Simply Becomes Kd.
Can You Please Explain This?
Interest is tax allowable – tax is calculated on the profit after subtracting the interest. This makes the cost of debt lower, because although they are paying interest they are also saving tax they would otherwise have had to pay. Therefore we use the after-tax cost off debt when calculating the WACC.
However they can only save all the tax provided the interest is less than the profit before interest. Suppose the profit before interest is zero and the interest is 120. The taxable profit is then zero, but as a result they are not saving tax on the interest because they would not be paying any tax anyway 🙂
This is a fairly minor point for the exam, and is never relevant in calculation questions in Paper FM.
(And, you will appreciate from my free lectures, that the cost of debt is only Kd(1-T) when the debt is irredeemable – when it is redeemable then we have to calculate the IRR of the after tax interest flows)
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