Your firm has a before-tax return of $1,800 on an investment of $800 and a marginal tax rate of 25%. The overall cost of capital is 10%. The firm currently uses 30% debt financing with an expected return of 7%. If it increases its use of debt to 40%, the expected return on the debt will be 8%.
-Refer to the information above. By how much will the present value of the tax subsidy increase (decrease)if the firm adopts the new capital structure?

Question

Quizplus · Accepted Answer

The present value of the tax subsidy increases because by increasing the use of debt, the firm is able to deduct more interest expenses, thus reducing its taxable income and increasing the value of its tax shield. With a higher expected return on the new debt, the firm benefits more from the tax deductibility of interest, leading to an increase in the present value of the tax subsidy.

Your Firm Has a Before-Tax Return of $1,800 on an Investment