Question

. Firm Green’s capital structure is 30% debt and 70% equity and firm Yellow’s capital structure is 50% debt and 50% equity. Both firms pay 6% annual interest on their debt. Firm Green’s shares have a beta of 1.0 and Firm Yellow’s a beta of 1.5. The risk-free interest rate is 3%, and the expected return on the market portfolio equals 8%.

(c) Discuss the impact of corporate taxes on the optimal capital structure of the firm in an otherwise perfect capital market.

Answer #1

Corporate Taxes reduce the cost of debt since Interest which is the financing cost of debt is tax deductible,

WACC= w_{d}* Cost of Debt + w_{e}* Cost of
Equity

Cost of Debt= Interest Rate (1-tax rate)

Cost of Equity= R_{f} + Beta (R_{m} -
R_{f}) ; R_{f=} Risk Free Rate R_{m}=
Market Risk

W_{d}= Weight of Debt

W_{e}= Weight of Equity

Proportion of Debt and Equity constitute the capital structure of the firm

Debt can be used as a leverage on capital to reduce the overall cost of capital. In an optimal capital structure, debt helps maximise returns on the capital.

Discuss the impact of corporate taxes on the optimal
capital structure of the firm in an otherwise perfect capital
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