Certified Financial Management Specialist Practice Exam

Which of the following describes a company that prefers debt over equity in its capital structure?

1. It is focused on maximizing shareholder equity

2. It aims to minimize financial risk

3. It is taking advantage of tax-deductible interest

4. It has a history of low revenue

The correct answer is: It is taking advantage of tax-deductible interest

A company that prefers debt over equity in its capital structure typically does so to take advantage of various financial benefits, one of the most significant being the tax-deductibility of interest payments on debt. When a company borrows funds, the interest it pays on that debt can be deducted from its taxable income, which reduces its overall tax burden. This creates a tax shield that can enhance the company's cash flow and, consequently, its ability to reinvest in growth opportunities or return value to shareholders. Additionally, using debt can lead to a higher return on equity if the company can effectively invest the borrowed funds at a rate of return greater than the interest cost. This reflects the principle of leveraging, where debt is seen as a tool to amplify potential returns for equity holders. Hence, the preference for debt in the capital structure stems from the financial strategy aimed at maximizing value while effectively managing the cost of capital. The other options focus on different aspects of corporate finance that do not align with a preference for debt over equity. For example, maximizing shareholder equity suggests a focus on equity finance, while minimizing financial risk generally implies using less debt. A history of low revenue might indicate financial difficulties, but it doesn't directly relate to a preference for debt financing in a structural sense.