Borrow and prosper - notes on the user cost of capital

Abstract

It is often argued that many firms can do very well by borrowing. The conclusion is based on two points which may be illustrated as follows. Firstly suppose that the effective rate of income tax is 50%, the nominal interest rate 8% and inflation 3%. Then the effective interest rate after deducting tax allowances on interest paid is 4% which is equivalent to a real interest rate of 1%. Now suppose that the nominal interest rate increases to 12% and inflation to 7%, then tax allowances reduce the effective interest rate to 6% and the real interest rate becomes negative. Variations on this theme are many.