Debt and taxes

Debt and taxes

1. 1. Permanent debt of $200M at 6% interest. Corporate tax rate 25%. What is the PV of the interest tax shield? Answer in $M.

   $M

2. 2. MM with corporate taxes says firm value as a function of debt is:

   V_L = V_U (debt irrelevant)V_L = V_U + t·D (rises linearly with debt)V_L = V_U − t·DV_L = V_U × (1 + D/V)

3. 3. Why doesn't WACC stay constant when taxes are introduced (compared to MM without taxes)?

   Because cost of equity fallsBecause the after-tax debt rate (1-t)·r_D is lower than r_D, so the weighted average tips toward the cheaper debt component as leverage risesBecause cost of debt rises with leverageBecause taxes are paid quarterly

4. 4. Pushed to its logical conclusion, MM-with-taxes implies firms should be:

   100% debt-financed (because the tax shield never stops adding value)100% equity-financed50% debt, 50% equityWhatever their industry average is