Unformatted text preview: e Corporate ﬁnancing and valuation 8.7 Introducing corporate taxes and cost of financial distress
When corporate income is taxed, debt financing has one important advantage: Interest payments are tax
deductible. The value of this tax shield is equal to the interest payment times the corporate tax rate, since
firms effectively will pay (1-corporate tax rate) per dollar of interest payment. (46) PV(Tax shield) interest payment corporate tax rate
expeced return on debt rD D TC
rD D TC Where TC is the corporate tax rate.
After introducing taxes MM's proposition I should be revised to include the benefit of the tax shield:
Value of firm = Value if all-equity financed + PV(tax shield)
In addition, consider the effect of introducing the cost of financial distress. Financial distress occurs when
shareholders exercise their right to default and walk away from the debt. Bankruptcy is the legal
mechanism that allows creditors to take control over the assets when a firm defaults. Thus, bankruptcy
costs are the cost associated with the bankruptcy procedure.
The corporate finance literature generally distinguishes between direct and indirect bankruptcy costs:
– – Direct bankruptcy costs are the legal and administrat...
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