Question

Company XYZ generates annual cash-flows equal to USD 1 million, in a perpetual way. For simplicity, we assume that the firm cost of equity and cost of debt are both equal to 10 percent, and the firm has a (perpetual) debt level equal to USD 1 million. Company XYZ is incorporated in a country that currently has a corporate tax of 0 percent. It follows that the market value of the assets of Company XYZ is USD 10 million. Suppose that the country announces unexpectedly that the marginal corporate tax rate is now equal to 10 percent. What is the change in the total market value of the assets of Company XYZ associated to the announcement?

Answer 1

The interest payable to the debt capital would be always tax deductible in nature and hence the tax rate would determine how much increase would be there due to change in the corporate tax structure as a whole.

Form has a debt financing of 1 million

Corporate tax rate which has been introduced at 10%

The overall cost of debt= 10%

hence the addition in the total market value of the company would be the tax shield on the interest payment which would be now protected by corporate rate tax introduction.

Addition in the market value=( 10% of 10,00000)* corporate tax rate

= (1,00,000*10%)

=$ 10,000

overall change in the positive side of total market value of firm equals to $b10,000