When corporate taxes and the cost of financial distress are taken into consideration,the market value of a firm equals the value if all-equity-financed _____ the PV of the tax shield _____ the costs of financial distress.

Question

Quizplus · Accepted Answer

When a firm is all-equity financed, there is no tax shield available from debt. Therefore, adding debt will increase the PV of the tax shield, which will increase the overall value of the firm. However, adding debt also increases the risk of financial distress, which will decrease the overall value of the firm. The net effect is that the value of the firm will increase if the PV of the tax shield is greater than the costs of financial distress. Therefore, the market value of a firm equals the value if all-equity-financed plus the PV of the tax shield minus the costs of financial distress.

When Corporate Taxes and the Cost of Financial Distress Are