Question

given corporate taxes, why does adding debt to the capital structure increase firm value? 1) extra cash flow goes to the firm's investors rather than the tax authorities. 2) earnings before interest and taxes are fully taxed at the corporate rate. 3) personal tax rates are the same as marginal corporate tax rates.

Answer 1

Adding debt to a firm's capital structure increases firm value due to lower tax liabilities and increased cash flows available to investors.

Adding debt to a firm's capital structure can increase firm value due to several factors:

1. Extra cash flow goes to the firm's investors rather than the tax authorities: When a firm takes on debt, the interest payments made to debt holders are deductible expenses, which reduces the firm's taxable income and consequently lowers its tax liability. This translates into higher cash flows available to be distributed to the firm's investors.
2. Earnings before interest and taxes (EBIT) are fully taxed at the corporate rate: By adding debt, the firm can reduce its taxable income, resulting in a lower tax liability. This increases the after-tax cash flows available to the firm's investors, thereby increasing firm value.
3. Personal tax rates are the same as marginal corporate tax rates: In most cases, personal tax rates are higher than marginal corporate tax rates. By using debt financing, individuals can benefit from the difference in tax rates and potentially pay lower taxes on the interest income received from the firm.