It has been suggested that in a world with only corporate taxation the value of the firm = the value of all equity financed + the present value of tax shield on debt finance Discuss how and why the existence of personal taxation might alter the choice of capital structure suggested in part (a) above
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
It has been suggested that in a world with only corporate
Discuss how and why the existence of personal taxation might alter the choice of capital
structure suggested in part (a) above
Capital structure of a firm signifies the mix of equity and debt used for financing the business.
According to the capital structure irrelevance theory from Modigllani & Miller (MM), given a set of assumptions, the value of a firm is unaffected by its capital structure.
This means that the value of a levered firm (firm financed by mix of equity and debt), and the value of an unlevered firm, (firm financed only by equity), are the same.
Value of levered Firm = Value of un-levered firm
The assumptions for this proposition are absence of taxes, no agency costs, no risk, no transaction costs, efficient markets, and no information asymmetry.
The modified MM proposition with inclusion of taxes as a factor, considers the impact of tax on debt financing, on the capital structure decision and the value of the firm.
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