Question

consider two companies a and b with the same capital structure, company a has relatively stable sales and low operating stress, company b has relatively volatile sales and high operating leverage. in addition, company a is subject to a higher tax rate than company b. which company should increase its debt ratio? why?

Answer 1

Company A should consider increasing its debt ratio due to its stable sales, low operating leverage, and the tax advantage due to higher tax rates, while Company B's volatile sales and high operating leverage make increasing debt riskier.

Step-by-step explanation:

The decision about whether Company A or Company B should increase its debt ratio depends on factors such as sales stability, operating leverage, and taxation. Company A, with stable sales and low operating leverage, is likely to be able to predict its earnings more reliably and cover debt interest payments without undue risk. The higher tax rate that Company A faces might also make debt financing more attractive due to the tax deductibility of interest expenses, providing a tax shield. In contrast, Company B's volatile sales and high operating leverage make it more susceptible to business cycles, which can be riskier when coupled with the fixed costs of debt interest payments. Therefore, it would typically be less prudent for Company B to increase its debt ratio compared to Company A.