The Effects of Long-Term Liabilities on Taxes
Long-term debt falls under the category of long-term liabilities on a company's balance sheet. Because the government allows a tax deduction for interest payments, profitable companies have an incentive to use long-term debt rather than equity financing to raise capital. However, too much debt increases a company's financial risk, placing it at risk of default.
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Long-Term Debt
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A company has an option to raise capital by issuing debt or equity. Raising money through an equity offering dilutes shareholder equity because the firm's income must spread across even more shareholders. For this reason, it is favorable for a profitable company to issue long-term debt, which appears as a long-term liability, rather than issue equity. In addition, dividend payments are not tax-deductible. Dividends are subject to double taxation at the corporate level and a shareholder's personal taxes.
Tax Advantages of Debt
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A company that issues long-term debt can write off the interest payments off on its taxes. For instance, if the company has a tax rate of 30 percent and issues bonds with a 6 percent coupon, it actually pays an effective interest rate of 4.2 percent (6 percent x (1 - 0.30) on those bonds.
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Pitfalls of Too Much Debt
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A high amount of long-term liabilities places a greater burden on management to be profitable enough to make its interest payments while running operations. Having too much debt increases a company's chances of default and leaves management with little room for error. In addition, too much long-term debt reduces a company's funding options. For example, banks and other institutional lenders take into consideration a company's ability to handle it current financial obligations, usually denying companies with too much leverage.
Insight
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A company with too much long-term debt receives a lower valuation from investors than a competitor with little or no debt, all else being equal. The fact that debt has a tax advantage should not obscure the fact that having to make a large interest payment each month reduces the company's cash flow from operations. In addition, several missed interest payments places the company at risk for bankruptcy liquidation, making the tax advantages of long-term debt a moot point anyway.
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