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1 Jan 2018

2. (13 points) Assume that a firm pays taxes on revenue and is allowed some deductions. a. (3 points) Derive and explain the user cost of capital if the firm's nominal interest payments are tax deductible. b. (2 points) Derive and explain the user cost of capital if the firm's real interest payments are tax deductible. c. (3 points) Derive and explain the user cost of capital if the depreciation of capital is tax deductible. d. (2 points) Derive and explain the user cost of capital if the firm's real interest payments and the depreciation of capital are tax deductible. e. (3 points) What is the impact of the tax on the firm's desired level of capital in the last case?

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Jarrod Robel
Jarrod RobelLv2
3 Jan 2018
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Related questions

Question 1: In making Capital Structure decisions, the overall objective is to:
a)minimize the firm's WACC
b)improve cash flows as much as possible
c)maximize the tax deductions the firm receives for interest expense
d)minimize the total amount of dividends and interest the firm needs to pay

Question 2 options: Which of the below statements is true?
a)Equity financing is permanent financing, while debt financing is temporary financing
b)Debt is normally a less expensive form of capital than equity
c)corporations cannot make dividend payments to both common and preferred shareholders during the same year
d)both interest expense and dividend payments are tax deductible for the firm making them

Question 3 options: As a firm's debt increases, its _______________ also increases. This makes the firm more risky and tends to increase the firm's _____.
a)market value / expected return
b)expected return / expected dividend payout
c)leverage / beta
d)systematic risk / unsystematic risk

When the assumptions of Modigliani and Miller’s Irrelevance Hypothesis regarding corporate capital structure are relaxed so that they are more consistent with real-world conditions, i.e. there are corporate taxes (and interest payments are tax deductible) and there are costs of financial distress, then which of the following is true?

Firm value and WACC are independent of the firm's capital structure.

Firm value increases and WACC decreases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value starts to decrease and WACC starts toincrease as more debt is added.

Each firm has an optimal capital structure where WACC is maximized.

Each firm has an optimal capital structure where firm value is minimized.

Firm value increases and WACC increases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value and WACC start to decrease as more debt is added.

When the assumptions of Modigliani and Miller’s Irrelevance Hypothesis regarding corporate capital structure are relaxed so that they are more consistent with real-world conditions, i.e. there are corporate taxes (and interest payments are tax deductible) and there are costs of financial distress, then which of the following is true? Firm value increases and WACC decreases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value starts to decrease and WACC starts to increase as more debt is added. Each firm has an optimal capital structure where firm value is minimized. Firm value increases and WACC increases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value and WACC start to decrease as more debt is added. Each firm has an optimal capital structure where WACC is maximized. Firm value and WACC are independent of the firm's capital structure.

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