Certified Energy Manager Practice Exam

What is a key advantage of debt financing under U.S. tax law?

1. Asset appreciation is guaranteed

2. Interest payments on debt are tax deductible

3. Equity shares are rewarded with profits

4. Debt payments do not affect net income

The correct answer is: Interest payments on debt are tax deductible

The key advantage of debt financing under U.S. tax law lies in the deductibility of interest payments on debt. This means that businesses can deduct the interest they pay on loans from their taxable income, effectively reducing the total tax burden. This feature of debt financing makes it an attractive option for companies looking to lower their tax liabilities while maintaining essential capital for growth or operations. By decreasing taxable income, interest deductions can improve cash flow and allow businesses to reinvest or allocate funds elsewhere. This tax advantage differentiates debt financing from equity financing, where dividends paid to shareholders do not come with a similar tax deduction. Thus, choosing debt over equity can provide substantial financial benefits, especially when managing the cost of capital. The other options do not accurately reflect the advantages of debt financing. For instance, asset appreciation is subject to market conditions and cannot be guaranteed, equity shares typically come with profit sharing that impacts cash flow and operate differently than debt obligations, and while debt payments do impact net income, they are accounted for differently than equity dividends, influencing financial ratios and operational metrics.