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# fm17 18 - takes away 40 of the income and hence 40 of the...

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There are two very important differences between these propositions and the zero-tax propositions: (1) when corporate taxes are added, V L does not equal V U ; rather, V L increases as debt is added to the capital structure, and the greater the debt usage, the higher the value of the firm. (2) r sL increases less rapidly when corporate taxes are considered. This is seen by noting that the Proposition II slope coefficient changes from (r sU – r d ) to (r sU – r d )(1 – t), so at any positive T, the slope coefficient is smaller. Note also that with corporate taxes considered, V U changes to V U = sU r ) T 1 ( EBIT = 14 . 0 ) 6 . 0 ( 000 , 500 \$ = \$2,142,857 versus \$3,571,429. This represents a 40% decline in value, and it is logical, because the 40% tax rate
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Unformatted text preview: takes away 40% of the income and hence 40% of the firm’s value. Looking at V L , we see that: V L = V U + TD = \$2,142,857 + 0.4(\$1,000,000) V L = \$2,142,857 + \$400,000 - \$2,542,857 versus \$2,142,857 for V U . Thus, the use of \$1,000,000 of debt financing increases firm value by T(D) = \$400,000 over its leverage-free value. To find r sL , it is first necessary to find the market value of the equity: D + S L = V L \$1,000,000 + S L = \$2,542,857 S L = \$1,542,857. now, r sL = r sU + (r sU- r d )(1 - T)(D/S) = 14.0% + (14.0% - 8.0%)(0.6)(\$1,000/\$1,543) = 14.0% + 2.33% = 16.33%. Mini Case: 17 - 18...
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