This implies that equityholders now pay fewer taxes

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shareholders. This implies that equityholders now pay fewer taxes. The taxes paid by debtholders will be more than offset since the corporate tax rate is greater than the rate paid by debtholders (20% versus 15%). So we will have a net tax savings resulting in an enhanced value for the firm. Second, the increase in debt can result in positive agency effects which can be captured by incorporating discount rates. We now have cash flows to debtholders that are discounted by a lower rate than those to unleveraged equityholders (5% rate versus 10% rate). Although, the leverage equity rate is greater than the unleveraged rate (12% versus 10%), its discrepancy is not as great as that between debtholders and unleveraged equityholders. Positive agency effects can result when firms increase debt. This is because fixed debt payments can help monitor managers’ behavior and lower the possibility that they will squander excess cash on bad projects.
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ANSWER (4): We still have α = 0.8470588 . However, D has changed. We now have: D = (1 – T d )CPN / r d = $58.823529 / 0.05 = $1.1764706B (even though the market value is only $1 billion because it does not include the taxes paid by debtholders). Inserting these values along with our other given values, we have: G L = [1 – ( α r d / r L )][D] – [1 – (r / r L )]E U = [1 – { 0.8470588(0.05) / 0.12}][$1.1764706B] – [1 – (0.10 / 0.12)]$2B = [1 – {0.3529411}][$1.1764706B] – [1 – 0.8333333]$2B = [0.6470588][ $1.1764706B] – [0.1666666]$2B = $0.4186851B – $0.333333333B = $0.0853518 or about $0.08535 billion . Although the gain to leverage is still positive, the value is lower than the previous values. We conclude that impact of leverage is not as great because of the increased risk from agency and financial distress (including bankruptcy costs) that can result when a firm increases its debt. V. Short Answers 76. What type of risk comes with leveraged? Financial risk results from the use of debt. This contrasts with business risk which results from the choice of assets. 77. What is capital structure? Capital structure is the makeup of the liabilities and stockholders’ equity side of the balance sheet, especially the ratio of debt to equity. 78. What is the perfect market view of capital structure? The perfect market view of capital structure is the analysis in a perfect capital market environment, which shows that a firm’s capital structure does not affect its value in a perfect capital market environment. 79. What does the corporate tax view of capital structure refer to? The corporate tax view of capital structure refers to the argument that double (corporate and individual) taxation of equity returns makes debt a cheaper financing method. 80. What does the personal tax view of capital structure refer to? The personal tax view of capital structure refers to the argument that the difference in personal tax rates between income from debt and income from equity eliminates the disadvantage from the double (corporate and individual) taxation of income from equity.
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