The change in firm value in the presence of corporate taxes is:
A) positive as equityholders face a lower effective tax rate.
B) positive as equityholders 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 change in firm value is positive in the presence of corporate taxes because of the added tax shield on debt interest. When a company takes on debt, it is able to deduct the interest paid on that debt from its taxable income. This reduces the overall income tax that the company must pay. Since the tax benefit of debt is greater than that of equity, the value of the firm increases when debt is used to finance the company's activities. Consequently, the equity holders' gain from the tax shield on debt interest.

The Change in Firm Value in the Presence of Corporate