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Standard models of investment usually incorporate various tax factors but often overlook "tax exhaustion," the case when a firm has negative taxable income and cannot claim immediately its tax deductions or credits.
Tax exhaustion occurs when a company has insufficient taxable profits to make use of all the tax available to it.
A further disincentive to high gearing is that the firm must be in a taxpaying position to obtain the tax shields on debt. At a certain level of gearing companies will discover that they have no taxable income left against which to offset interest charges.
After this point firms will experience all the problems of gearing but none of the advantages. The level of investment can also affect the point at which tax exhaustion occurs. This is because capital allowances granted on capital investments will reduce taxable profits.
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