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In the context of corporate finance, the
tax benefits of debt or tax advantage of debt refers to the fact
that from a tax perspective it is cheaper for firms and investors to finance
with debt than with equity. Under a majority of taxation systems around the
world, and until recently under the U.S. tax system, firms are taxed on
their profits and individuals are taxed on their personal income.
For example, a firm that earns $100 dollars
in profits in the U.S. would have to pay around $30 dollars in taxes. If it
then distributes these profits to its owners as dividends, then the owners
in turn pay taxes on this income, say $20 on the $70 dollars of dividends.
The $100 dollars of profits turned into $50 dollars of investor income.
If, instead the firm finances with debt,
then, assuming the firm owes $100 dollars of interest to investors, its
profits are now 0. Investors now pay taxes on their interest income, say $30
dollars. This implies for $100 dollars of profits before taxes, investors
got $70 dollars.[1]
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