Question

Despite MM's original theory on the value of a company related to its capital structure, the theory assumed no taxes. In the lecture videos, I reviewed scenarios where there could be reasons why debt could help increase firm value. So, given corporate taxes, why could adding debt the capital structure increase firm value?

Group of answer choices

O Earnings before interest and taxes are fully taxed at the corporate rate.

O Personal tax rates are the same as marginal corporate tax rates

O Extra cash flow goes to the firm's investors rather than the tax authorities.

O Earnings before interest and taxed at the corporate rate, and personal tax rates are the same as marginal corporate tax rates

Answer 1

Adding debt to the capital structure can increase firm value because the tax shield on interest payments allows extra cash flow to go to the firm's investors rather than the tax authorities.

Option C is correct.

In the presence of corporate taxes, adding debt to the capital structure can increase firm value due to the tax shield benefit associated with interest expense. The specific reason among the given choices is:

Extra cash flow goes to the firm's investors rather than the tax authorities.

When a firm borrows money, it incurs interest expenses on the debt. Interest payments are tax-deductible, meaning they reduce the firm's taxable income. As a result, the firm pays less in taxes, leading to an increase in after-tax cash flows. This additional cash flow is retained by the firm and can be used to benefit shareholders, either through reinvestment in projects, dividend payments, or share repurchases.

The tax shield on interest payments creates a financial advantage for debt financing. This benefit is especially relevant when the corporate tax rate is substantial. By adding debt to the capital structure, a firm can optimize its tax position and enhance shareholder value by retaining more cash within the company.

This aligns with the fundamental principle of the trade-off theory of optimal capital structure, where the tax advantage of debt is considered a key factor in determining the optimal mix of debt and equity to maximize firm value.