If the after-tax cost of debt is always less expensive than equity, why don’t firms use more debt and less equity?

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Companies must weigh the risks and benefits of each type of capital when deciding how much to borrow relative to equity. While debt financing is less costly than equity financing in terms of after-tax costs, it may also be more risky as creditors have the right to repay shareholders. Companies that acquire more debt risk increasing their financial leverage. They also become more susceptible to bankruptcy risk, if the company cannot pay their obligations. Firms should seek to balance the costs and benefits of different capital sources in order to attain optimal levels of leverage.

Other factors are also considered by firms when they decide how much equity to take on. Equity investors are more tolerant towards short-term losses as compared with creditors who demand timely interest payments no matter what shape the firm’s finances are in; as such this affects a firm’s ability to take on higher levels of financial risk when considering new investments or strategic decisions. Additionally, taxes play an important role in the choice over different sources of capital since income generated from debt can often be deducted for tax purposes – further reducing its effective cost for firms. Finally, certain regulations can also impact how equity and debt are used by companies. These restrictions may differ between countries or regions.

In summary, although after-tax costs typically favor using more debt over equity when making investment decisions, there is not always a simple answer as various factors need to be considered before determining the appropriate mix of both sources of capital – each with their own set of costs and benefits attached.

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