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chapter15_2_a

chapter15_2_a - Chapter 15-2 Capital Structure with Taxes 6...

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Chapter 15-2 Capital Structure with Taxes

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6. Corporate Taxes and Capital Structure Interest is deductible from corporate taxes, dividends are not deductible Example : Company is considering two ways of financing a project that generates \$1,000,000 in pre-tax cash flow each year. Corporate tax rate T C =35% Plan 1: equity finance Plan 2: debt finance with D=4,000,000, r D = 10% Plan 1 Plan 2 1,000,000 0 1,000,000 (400,000) 1,000,000 (350,000) 600,000 (210,000) 650,000 390,000 Earnings before interest and corporate taxes (EBIT) Interest = r D D Earnings before taxes Taxes Earnings after taxes Total cash flow to all investors- equity and debt
Conclusion from example: General Algebraic expressions: Earnings after taxes for an all-equity firm: EBIT x (1 – T C ) Taxable income for a levered firm: EBIT - r D D Total taxes paid by a levered firm: T C x (EBIT – r D D) Total cash flow for stockholders and bondholders in levered firm: EBIT – [T C x (EBIT – r D D)] = EBIT x (1- T C ) + T C r D D

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Valuing the tax shield How valuable is the annual tax shield from debt?
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chapter15_2_a - Chapter 15-2 Capital Structure with Taxes 6...

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