Topic 3 Capital Structure II: Debt and Taxes

Question 1

Takeaway = If tax subsidies for debt

Answer 1

The value of the firm should increase due to decreasing cost of debt due to interest tax shield thus increases the value of the levered firm relative to the unlevered

Question 1

MM Prop I with Taxes

Answer 1

VL =VU +PV(Int. Tax Shield)

Question 2

Tax shield

Answer 2

-discounted at the unlevered firm’s cost of capital, ie unlevered cost

Question 3

MM Prop II with taxes

Answer 3

-Leverage increases the risk and cost of equity; leverage and taxes increase the value of the firm due to interest tax shield

Question 4

MM prop II Int Tax Shield and Permanent Debt

Answer 4

Re = RU +[1-t(c)]D/E(RU-Rd)
-derived by MM where leverage adds financial risk to equity

Question 5

MM prop II Int Tax Shield and Constant Leverage Ratio

Answer 5

Constant Leverage Ratio D/E in perpetuity
-firm must constantly rebalance to keep the ratio unchanged
Re=Ru+D/E(Ru-Rd)
-formulas do not depend on tax rate in this case

Question 6

Interest Tax Shield and Recapitalization

Answer 6

When securities are fairly priced, the original shareholders of the firm capture the full benefit of the interest tax shield from an increase in leverage

Question 7

WACC with Taxes

Answer 7

-reflects the risk of assets fo the fimr
-reflects the tax deductibility of interest
-assets only need to earn Rd(1-t(c)) to pay debt holders Rd
Rwacc = (E/E+D)Re+(D/E+D)Rd(1-t(c))

Question 8

Personal Taxes Effect

Answer 8

because bond investors may end up paying a higher tax rate in personal taxes rather than what the shield is actually saving in total
-such that if interest income is taxed at higher rate than equity income from dividends then the debt advantage is less than corporate tax rate
->Therefore personal taxes may decrease the advantages of debt!

Question 9

Limits to Tax Benefit

Answer 9

-Only exists if the firm pays taxes
-Has to be under maximum allowable deduction
->High earning growth firms will have lower debt levels