CORPORATE TAXES - (A) In an attempt to balance the budget, Congress just increas

Question

CORPORATE TAXES -

(A) In an attempt to balance the budget, Congress just increased the corporate income tax rate to 75%. How will most firms change their debt-equity (D/E) ratio in response to this? What will that D/E change probably do to personal taxes paid by investors (even if personal tax rates are unchanged)? What will that change in D/E do to bankruptcy costs?

CAPITAL STRUCTURE -

(B) If a firm has $25 million of debt and $75 million of equity, what fraction of the firm's value was financed with debt?

Explanation / Answer

(A)

SAY Ti = TAX ON DEBT, Tc= CORPORATE TAX, Te= TAX ON DIVIDEND INCOME

SO AFTER TAX CASHFLOW TO DEBT HOLDERS = INTEREST (1-Ti)

AFTER TAX CASH FLOW TO EQUITY HOLDERS = DIVIDEND OR CAPITAL GAIN (1-Tc)(1-Te)

NOW AS TAX INCREASES, THAT IS , Tc INCREASES,

AND COST OF DEBT IS LOWER THAN COST OF EQUITY AND WITH INCREASE IN COPORATE TAXES, DEBT BECOMES MORE FAVOURABLE, WHICH LEADS TO MORE BORROWINGS

SO EFFECTIVELY, THE DEBT EQUITY (D/E) RATIO WILL GO UP.

NOW AS DEBT-EQUITY RATIO GOES UP, IT INCREASES THE RISK OF BANKRUPTCY WHICH IMPLIES HIGHER BANKRUPTCY COSTS.

(B)

DEBT = 25 MILLION AND EQUITY = 75 MILLION

TOTAL ASSETS = TOTAL LIABILITIES = 25 + 75 = 100

THEREFORE FIRM'S VALUE FINANCED WITH DEBT = 25/100 = 25%

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