The interest tax shield has no value for a firm when the I.tax rate is equal to zero.
II)debt-equity ratio is exactly equal to 1.
III)firm is unlevered.
IV)firm elects an all-equity capital structure.
A)I and III only
B)II and IV only
C)I,III,and IV only
D)II,III,and IV only
E)I,II,and IV only

Question

Quizplus · Accepted Answer

The interest tax shield is the tax benefit that a company receives by deducting the interest paid on debt from its taxable income. If the tax rate is zero, then there is no tax to be shielded, and therefore, no value to the firm.

If the debt-equity ratio is exactly equal to 1, then the firm is equally financed by debt and equity. This means that the firm is levered, and thus, there is some value to the interest tax shield. Therefore, option II is not correct.

If the firm is unlevered, then it has no debt in its capital structure. As a result, there is no interest tax shield, and option III is correct.

If the firm elects an all-equity capital structure, then it has no debt to benefit from the interest tax shield. Therefore, option IV is correct.

In summary, options I, III and IV are correct, making option C the best choice.

The Interest Tax Shield Has No Value for a Firm