They mention that interest is tax deductible, so you pay lower taxes. But the tax is lower because your EBT is lower than your EBT if you didn't take on debt. I understand that taking on debt benefits all investors (more than 100% equity) But I fail to see how it is cheaper. Especially if you have to pay a lot on the long run.

  • 2
    $\begingroup$ Welcome back! Could you please define "They" and EBT? $\endgroup$ – emeryville Apr 23 at 17:38
  • $\begingroup$ Look at the return on equity as a percentage, not the absolute profit. $\endgroup$ – Brian Romanchuk Apr 24 at 0:31

I assume EBT = Earnings before tax.

Take a \$200 project with a 6% return on assets. If 109% equity financed, EBT = \$12 (6% return).

If debt has a cost of 5%, and 50% financed (\$100 borrowed), earns \$12 - \$5 = \$7, or a 7% return on equity. So the rate of return is higher, even though total earnings are less.

However, if interest were not deductible, would need to pay taxes on the \$12 pre-interest earnings, not the \$7, and so rate of return would be lower with a high enough tax rate. (E.g., if the tax rate is 50%, there would be \$2.50 paid on the cash flow required for interest, and the rate of return would be lower than a 100% equity investment.)

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