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.