Explain financial leverage, tax implications of debt

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What are the tax implications of debt financing? Explain the term financial leverage as it relates to debt.

A company can raise funds either through debt or equity. Debt financing is a mode of raising finance through the sale of bonds, notes, debentures and other financial instruments to raise capital for capital expenditures and working capital needs. In return for providing the company with capital, the creditors (as they are referred to) expect an interest for the period till the debt is repaid.

Financing your needs through debt has some tax implications. These vary depending upon the borrowers' status. In case of corporations and businesses, the interest expense on debt is tax deductible. This provides them with the opportunity to increase the return on invested capital. Taxes are often considered with the treatment of debt financing. Debt management is affected by:
1) Interest payments as deductible expenses
2) Treatment of capital losses (or gains)
3) Valuation with Adjusted Present Value (tax shields)

In case the borrower is an individual, the tax benefits are restricted on certain types of debt financing only. The most common debt financing that entitles the borrower to claim interest as tax deductible is the housing loan.

The term leverage refers to the use of debt to supplement income. It means borrowing money for the purpose on earning returns from the borrowed money. Financial leverage refers to the process of borrowing money for the purpose of investing with intent to earn a return greater than the cost of borrowings i.e. interest costs. It carries with it a certain amount of risk as if the investments from borrowed funds do not yield a return higher than the cost of borrowings, the company's Return on Equity will reduce. It also has ...