The value of this tax shield is equal to the interest

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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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