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

Question

Quizplus · Accepted Answer

When considering corporate taxes, the value of a firm is increased, hence the "plus" sign next to the first term. The PV of the tax shield also adds value to the firm as it provides a benefit from tax deductions, hence another "plus" sign. However, the costs of financial distress, such as bankruptcy or default, decrease the value of a firm, hence the "minus" sign next to the third term. Therefore, we arrive at the equation:

Value of firm = Value of all-equity financed + PV of tax shield - PV costs of financial distress

or

V = E + PVTS - PVFDC

where:
V = value of firm
E = value of all-equity financed
PVTS = present value of tax shield
PVFDC = present value of costs of financial distress

When Corporate Taxes and the Cost of Financial Distress Are