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Debt versus Equity Financing (Interest versus Dividends)

Aside from taxes, another important difference between debt and equity financing is that debt payments must be made to avoid default, while firms have no similar obligation to pay dividends. How do debt and equity financing affect a firm's tax situation differently? Why do debt payments have to be made but dividends do not have to be paid?

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Dividends are not required to be paid by law. Dividends are paid out of excess profits or reserves and are declared and subsequently paid at the company's discretion. A company won't pay dividends if it is going to bankrupt the company, as it would be a financial decision that would devastate shareholders. ...

Solution Summary

This solution explains how debt and equity financing affect a firm's tax situation differently, and why debt payments have to be made but dividend payments do not have to be paid.

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