Question

What effect does a decrease in corp tax rate have on the value of a levered company?

Answer 1

A decraese in corporate tax will decrese the value of the firm. Corporations pay taxes on their profits after interest payments are deducted. Thus, interest expense reduces the amount of corporate taxes. This creates an incentive to use debt. A levered firms value os the present value of it's future cash flows. Cost of debt is one of the components of weighted average cost of capital. A higher tax rate will reduce the cost of debt. A lower tax rate will have a higher cost of debt. a higher cost of debt will in turn increases the WACC. since WACC is the discount rate used to value the company, A company with a lower tax rate will have a higher WACC which decreases the value of the levered company.