The change in firm value due to infusion of debt in the presence of corporate taxes is:
A) positive as equity holders face a lower effective tax rate.
B) positive as equity holders gain the tax shield on the debt interest.
C) negative because of the increased risk of default and fewer shares outstanding.
D) negative because of a reduction of equity outstanding.

Question

Quizplus · Accepted Answer

The correct answer is B because the infusion of debt into a firm's capital structure allows the firm to benefit from the tax shield on the debt interest. This tax shield arises because interest payments on debt are tax-deductible, reducing the firm's taxable income and thus its tax liability. This reduction in taxes increases the firm's value.

The Change in Firm Value Due to Infusion of Debt