Question

1. What is the relationship between the value of an unlevered firm and the value of a levered firm once we consider the effect of corporate taxes?

2. If we consider only the effect of taxes, what is the optimum capital structure

Answer 1

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Answer:

1)

Using these parameters, the relationship between the value of an unlevered firm and the value of levered firm once we consider the effects of corporate taxes can be given as shown below:

Where,

(T X D) represents the interest tax shield. So, the value of levered firm is more than the value of unlevered firm by the amount of interest tax shield once corporate tax is considered.

2)

As it is explained in previous part that the value of levered firm is more than the value of unlevered firm by the amount of interest tax shield once corporate tax is considered

That means, the value of levered firm keeps increasing with the level of debt if we only consider corporate tax and forgets about the financial distress. In this case, the optimum capital structure will be one that has 100 % debt.