Tc X D

The effect of borrowing in this case is illustrated in Figure 17.4. We have plotted the value of the levered firm, VL, against the amount of debt, D. M&M Proposition I with corporate taxes implies that the relationship is given by a straight line with a slope of TC and a y-intercept of Vv.

In Figure 17.4, we have also drawn a horizontal line representing V^. As indicated, the distance between the two lines is TC X D, the present value of the tax shield.

Suppose that the cost of capital for Firm U is 10 percent. We will call this the unlevered cost of capital, and we will use the symbol Rv to represent it. We can think of Rv as the cost of capital a firm would have if it had no debt. Firm U's cash flow is $700 every year forever, and, because U has no debt, the appropriate discount rate is Rv = 10%. The value of the unlevered firm, V^, is simply:

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

17. Financial Leverage and Capital Structure Policy

© The McGraw-Hill Companies, 2002

CHAPTER 17 Financial Leverage and Capital Structure Policy

M&M Proposition I With Taxes

Taming Taxes

Taming Taxes

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