Question

Assume firm A has high leverage, firm B has low leverage. Everything else about the firms are the same. Both are highly profitable. Assume neither of the firms has any depreciation. Assume the only friction is tax. When corporate tax rate increases, what happens to the value of the two firms?

• A.Value of both firms will decrease by the same amount A
• B.Value of both firms will increase, the increase will be larger for firm A
• C.Value of both firms will decrease, the decrease will be larger for firm B
• D.Value of firm A will decrease, value of firm B will increase
• E. Value of both firms will increase by the same amount
• F.Value of firm A will increase, value of firm B will decrease
• G.Value of both firms will increase, the increase will be larger for firm B
• H.Value of both firms will decrease, the decrease will be larger for firm A

Answer 1

Answer H The Value of both firms will decrease, the decrease will be larger for firm A

Since the A has lower amount of interest, its tax shield is lesser as compare to firm B. This can be shown as follows.

Assumption everything including cost of equity , except the degree of leverage is same for A & B.

		Tax Rate 25%	Tax Rate 45%
		A	B	A	B
	EBIT	100000	100000	100000	100000
Less	Int	-20000	-30000	-20000	-30000
	EBT	80000	70000	80000	70000
Less	Taxes	-20000	-17500	-36000	-31500
	EAT	60000	52500	44000	38500
Less	Preference Dividend	0	0	0	0
	Earning for Equity Share	60000	52500	44000	38500
	Ke	0.15	0.15	0.15	0.15
	Equity	400000	350000	293333.3	256666.7
Add	10% Debt	200000	300000	200000	300000
	Value of Firm	600000	650000	493333.3	556666.7
	Decrease in Value			106666.7	93333.33
	Percentage Decrease in Value		0.1778	0.1436