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One advantage of borrowing money is that interest expense is tax deductible. Therefore, a company will essentially recoup a portion of its interest expense from the government. As mentioned above, Target incurred interest expense of $900 million. This interest reduced the company’s taxable income by that amount. If the assumption is made that Target has an effective income tax rate of 35 percent, the income tax total paid to the government is lowered by $315 million (35 percent of $900 million). Target pays interest of $900 million but reduces its income taxes by $315 million so that the net cost of borrowing for the period was $585 million. Another advantage associated with debt financing is that it can be eliminated. Liabilities are not permanent. If the economic situation changes, a company can rid itself of all debt simply by making payments as balances come due. In contrast, if money is raised by issuing capital stock, the new shareholders can maintain their ownership indefinitely.
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However, the biggest advantage commonly linked to debt is the benefit provided by financial leverage. This term refers to an organization’s ability to increase reported net income by earning more money on borrowed funds than the associated cost of interest. For example, if a company borrows $1 million on a debt that charges interest of 5 percent per year, annual interest is $50,000. If the $1 million can then be used to generate a profit of $80,000, net income has gone up $30,000 ($80,000 – $50,000) using funds provided solely by creditors. The owners did not have to contribute any additional funds to increase profits by $30,000. Over the decades, many companies have adopted a strategy of being highly leveraged, meaning that most of their funds came from debt financing. If profitable, the owners can make huge profits with little investment of their own. Unfortunately, companies that take this approach have a much greater risk of falling into bankruptcy because of the high volume of debts that have to be serviced.
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