FIN-3403 Lecture Notes - Lecture 16: Tax Shield, Capital Structure, Root Mean Square
Document Summary
Financial management of the firm - chapter 16 notes. Third party who gets a share of the pie - tax revenue from government. Since interest is tax deductible, as debt increases, more cash ows are reserved for the shareholders and debt holders. The more dollars of debt outstanding, the bigger the present value of the tax savings is going to be, the more value added to the rm. Case iii: a world with corporate taxes and bankruptcy costs. Key disadvantage of using of debt is bankruptcy costs. Legal and administrative expenses directly associated with bankruptcy. Dif culties in hiring and retaining good people because the rm is in nancial dif culty. Hard to measured generally take the form of forgone revenues, opportunity costs. As debt increases, the risk of bankruptcy and associated costs increase. The optimal capital structure is where these increased costs exactly offset the interest tax shield. Firms borrow because tax shields are valuable.
