Sample Essay

However, to the extent that there is capital market imperfections, changes occur in the capital structure. One of the most important imperfections is the presence of taxes.

 The advantage of debt in a world of corporate taxes is that interest payments are deductible as an expense. They elude taxation at the corporate level, whereas dividends or retained earnings associated with stock are not deductible by the corporation for tax purposes. Consequently, the total amount of payments available for both debt holders and stockholders is greater if debt is employed. Implied is that the risk associated with the tax shield is that of the stream of interest payments, so the appropriate discount rate is the interest rate on the debt. Thus, the value of the firm is

Value of firm = Value if + Value of

                                                Unlevered       tax shield

The tax savings associated with the use of debt are not certain. If reported income is consistently low or negative, the tax shield on debt, as denoted by t_cB, is reduced or even eliminated. As a result, the near full or full cash-flow burden of interest payments would be felt by the firm. If the firm should go bankrupt and liquidate, the potential future tax savings associated with debt would stop altogether. The greater the possibility of going out of business, the greater the probability the tax shield will not be effectively utilized. These entire things make the tax shield associated with debt financing less than certain.

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