Question

Ignore financial distress costs. When [(1 − TC) × (1 − TS) = (1 − TB)],...

Ignore financial distress costs. When [(1 − TC) × (1 − TS) = (1 − TB)], then firms:

a. should be all-equity financed.

b. discover that both dividends and interest payments are non-deductible business expenses.

c. tend to be indifferent between issuing debt or issuing equity.

d. need to maintain a debt-equity ratio of .5.

e. can reduce their taxes by increasing their dividend payouts.

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Answer #1

As per the MM model with corporate and personal taxes,

VL = Vu + [1 - (1-Tc)*(1-Ts)/(1-Tb)]*D where

VL = value of the levered firm

Vu = Value of the unlevered firm

Tc = corporate tax; Ts = personal tax on income from stocks; Tb = tax on income from debt

If (1-Tc)*(1-Ts) = (1-Tb) then value of levered firm will be equal to the value of the unlevered firm, irrespective of the debt which it has or independent of its capital structure. So, the firm will be indifferent between issuing debt or issuing equity as it would have no effect on firm value. Option (c) is correct.

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