1.Joseph Palmer is discussing the impact of the tax shield provided by debt with his supervisor, Ming Chou. During the course of their discussion, Palmer makes the following statements:

Are Palmer’s statements accurate?

A)                                  No                 No

B)                                 Yes               No

C)                                  Yes                Yes

D)                                  No                 Yes

2.Davis Streng, the corporate controller for the Cannizaro Corporation has been researching Modigliani and Miller’s (MM) theories on capital structure. Streng would like to apply the theories to his firm’s capital structure, but does not agree with MM’s assumption of no taxes, since Cannizaro has a 40 percent tax rate. If Streng removes the assumption of no taxes, but keeps all of MM’s other assumptions, which of the following would be the optimal capital structure for maximizing the value of the firm?

A)   100% equity.

B)   100% debt.

C)   The capital structure Streng chooses is irrelevant.

D)   50% debt and 50% equity.

3.Katherine Epler, a self-employed corporate finance consultant, is working with her newest client, Harbor Machinery. Epler is discussing various capital structure theories with her client, and makes the following comments.

Comment 1: If we remove the assumption of no taxes from Modigliani and Miller’s theory regarding capital structure, and if the firm holds some proportion of debt, increases in the corporate tax rate will increase the value of the firm.

Comment 2: If we also include the costs of financial distress in Modigliani and Miller’s assumptions, the optimal capital structure will not contain any debt financing.

Are Epler’s comments correct?

A)          Yes                                        Yes

B)          No                                           No

C)          No                                           Yes

D)          Yes                                         No

1.Joseph Palmer is discussing the impact of the tax shield provided by debt with his supervisor, Ming Chou. During the course of their discussion, Palmer makes the following statements:

Are Palmer’s statements accurate?

A)                                  No                 No

B)                                 Yes               No

C)                                  Yes                Yes

D)                                  No                 Yes

The correct answer was D)

Palmer’s first statement is incorrect. The calculation Palmer describes is the calculation for the after-tax cost of debt. The value of a tax shield is equal to the marginal tax rate times the amount of debt in the capital structure. Palmer’s second statement is correct. The tax shield adds value to the firm so that the value of a levered firm is greater than the value of an unlevered firm, all else equal.

2.Davis Streng, the corporate controller for the Cannizaro Corporation has been researching Modigliani and Miller’s (MM) theories on capital structure. Streng would like to apply the theories to his firm’s capital structure, but does not agree with MM’s assumption of no taxes, since Cannizaro has a 40 percent tax rate. If Streng removes the assumption of no taxes, but keeps all of MM’s other assumptions, which of the following would be the optimal capital structure for maximizing the value of the firm?

A)   100% equity.

B)   100% debt.

C)   The capital structure Streng chooses is irrelevant.

D)   50% debt and 50% equity.

The correct answer was B)

If MM’s other assumptions are maintained, removing the no tax assumption means that the value of the firm is maximized when the value of the tax shield is maximized, which occurs with a capital structure of 100% debt.

3.Katherine Epler, a self-employed corporate finance consultant, is working with her newest client, Harbor Machinery. Epler is discussing various capital structure theories with her client, and makes the following comments.

Comment 1: If we remove the assumption of no taxes from Modigliani and Miller’s theory regarding capital structure, and if the firm holds some proportion of debt, increases in the corporate tax rate will increase the value of the firm.

Comment 2: If we also include the costs of financial distress in Modigliani and Miller’s assumptions, the optimal capital structure will not contain any debt financing.

Are Epler’s comments correct?

A)          Yes                                        Yes

B)          No                                           No

C)          No                                           Yes

D)          Yes                                         No

The correct answer was D)

Epler’s first comment is correct. The tax deductibility of interest payments provides a tax shield that adds value to the firm. The value of a tax shield is equal to the marginal tax rate times the amount of debt in the capital structure, so the higher the tax rate, the greater the value of the tax shield and the value of the firm, all else equal. Epler’s second comment is incorrect. If the costs of financial distress are also included in MM’s assumptions, we get the static-tradeoff theory, where the firm will have debt in its capital structure up to the point where the marginal cost of financial distress exceeds the marginal value provided by the tax shield.