Question

Paying interest reduces the taxes owed by a firm. Which one of the following terms applies to this relationship?

A. Static theory of interest rates

B. M&M Proposition I

C. Financial risk

D. Interest tax shield

E. Homemade leverage

Answer 1

The term that applies to the relationship between paying interest and reducing a firm's taxes is the Interest Tax Shield. It represents the tax savings achieved by deducting interest payments on debt from taxable income, thereby reducing the total taxes owed. Therefore correct option is D

Step-by-step explanation:

The relationship between paying interest and reducing the taxes owed by a firm is described by what is known as the Interest Tax Shield. This concept refers to the tax saving that results from deducting interest payments on debt from a company's taxable income.

Since interest is a tax-deductible expense, it reduces the firm's taxable income and thus the amount of tax it owes. This can result in significant savings for the firm, especially if it has a substantial amount of debt. For instance, if a firm is in a 30% tax bracket and it pays $1,000,000 in interest, it would save $300,000 in taxes due to the interest tax shield.