What is the opportunity cost of
(a) borrowed funds and
(b) equity capital?
Under current tax law, firms can record as an expense the opportunity cost of borrowed funds, but not equity capital. How does this tax law affect the amount of debt the firm wants to incur, compared with the amount of money it raises by selling equity?
Answer
a) The interest that must be paid for borrowing funds is known as the opportunity cost of borrowed funds.
b) The interest income that will be foregone is the opportunity cost of equity capital.
Because a company's tax burden is negatively (or inversely) connected to its debt/equity ratio, the existing tax rules will favour debt financing rather than equity financing.
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