fm17 19 - (1) the cost of debt is lowered by (1 - T), and...

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Firm L’s WACC is 11.8 percent: WACC L = (D/V)r d (1 - T) + (S/V)r s = ($1,000/$2,543)(8%)(0.6) + (1,543/$2,543)(16.33%) = 1.89% + 9.91% = 11.8%. The WACC is lower for the levered firm than for the unlevered firm when corporate taxes are considered. Figure 3 below plots capital costs at different D/V ratios under the MM model with corporate taxes. Here the WACC declines continuously as the firm uses more and more debt, whereas the WACC was constant in the without-tax model. This result occurs because of the tax deductibility of debt financing (interest payments), which impacts the graph in two ways:
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Unformatted text preview: (1) the cost of debt is lowered by (1 - T), and (2) the cost of equity increases at a slower rate when corporate taxes are considered because of the (1 - T) term in Proposition II. The combined effect produces the downward-sloping WACC curve. Figure 4 shows that, when corporate taxes are considered, the firms value increases continuously as more and more debt is used. Figure 3 With Taxes 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 0% 20% 40% 60% 80% 100% Debt/Value Ratio Cost of Capital rs WACC rd x (1-T) Mini Case: 17 - 19...
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