Ch 18 Flashcards
(17 cards)
What is the formula for calculating the interest tax shield?
Interest × Corporate Tax Rate
How does debt create value for a firm under taxes?
By reducing taxable income, which generates tax savings called the interest tax shield.
Who ultimately benefits from the interest tax shield?
Both debt and equity holders—through higher total cash flows.
How do you value the tax shield from fixed-term debt?
Use the annuity present value formula.
How do you value the tax shield from perpetual debt?
PV = Tax Rate × Debt
How do you value tax shields under a constant debt/equity ratio?
Use the difference: VL – VU, where VL is the levered firm value and VU is the unlevered firm value.
When debt changes yearly, how do you value the tax shield?
Calculate and discount each year’s tax savings individually.
What discount rate is used for valuing tax shields on perpetual debt?
Cost of debt
What discount rate is used when valuing tax shields under a constant D/E ratio?
Pre-tax WACC (i.e., RU or the asset cost of capital)
What is the revised MM Proposition I under corporate taxes?
VL = VU + PV(Interest Tax Shield)
How does adding debt affect firm value under the tax-based MM Proposition?
Increases it by the present value of tax shields from interest.
What is the after-tax WACC formula?
WACC = E/V × Re + D/V × Rd × (1 – Tc)
Why is after-tax WACC lower than pre-tax WACC?
Because the cost of debt is reduced by the tax shield (1 – Tc).
What is a leveraged recapitalization?
A firm issues debt and repurchases equity to increase leverage and create a tax shield.
Why does share price typically rise after announcing a recapitalization?
Investors expect higher future cash flows due to the added tax shield.
What happens if a firm holds large excess cash reserves?
It can create a negative tax shield by generating taxable interest income.
What determines the optimal capital structure?
The tradeoff between tax benefits of debt and financial distress/agency costs.
