Question

1 a. Evaluate the relationship between the value of unlevered firm and the value of a levered firm if corporate taxes are taken into consideration.

b. Describe the trade-off that defines the static theory of capital structure.

Answer 1

1 a. Unlevered Firm means the firm is equity financed or no debt included in its capital structure, whereas levered firm is having debt in its capital structure.

Corporate taxes are levied on the net income (after considering all the expenses).

Value of Levered firm is equal to the value of Unlevered firm plus the tax benefit on interest paid on debt, because interest paid on debt is tax deductible.

Hence the value of unlevered firm is = Vu +(T*D)

where,

Vu= Value of unlevered Firm

T= Corporate Tax rate

D= Debt

1 b). Debt Financing is always considered to be cheaper than the equity financing, due the tax shield on the interest payments. Static theory of capital structure tries to balance between the two. this theory also tries to give an optimal mix of equity & debt finance.