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.

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