Question

A firm has recently adjusted its capital structure from 30% debt ratio to 50% debt ratio. Assume there are no other changes in the market and all the assumptions of MM (with tax) hold. What will happen to the values of the following items?

Present value tax shields |
Answer 1Choose...IncreaseUnchangedDecrease |

WACC before tax |
Answer 2Choose...IncreaseUnchangedDecrease |

Firm value |
Answer 3Choose...IncreaseUnchangedDecrease |

WACC after tax |
Answer 4Choose...IncreaseUnchangedDecrease |

Answer #1

according to mm theroy cost of capital of the firm is independent of capital stracture where there is no tax

according to mm propotion 2 value of the firm will increase by present value of tax sheild when debt is incrased

1- pv of tax sheild will increase as debt is increased

2- wacc before tax will not change (mm propotion 1 )

3- firm value will increase ( mm propotion 2)

4- wacc after tax will **decrease,** as interest
payment are tax deductable ( mm propotion 2)

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