Question

a) One of the conditions that the M&M Propositions required was for there to be no tax. Briefly discuss whether the introduction of tax decreases or increases the value of a company b) Briefly explain how an increase in the amount of debt that a company has outstanding may actually decrease the agency costs caused by the conflict between managers and shareholders

Answer 1

a)Introduction of tax increase the value of a company with debt in its capital structure.Ultimate tax burden of a company with debt in its capital structure is lower than than a company with zero or lower debt because interest payment is tax deductible.The main rationale behind this is that tax deductible interest payment positively affect a company's cash flows.Since a company's value is determined as the present value of the future cash flows,the value of the levered company is increses.