Capital structure doesnot matter due to homemade leverage

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Reference no: EM131559729

Based on M&M theory with no tax, capital structure doesn't matter due to homemade leverage. However, no tax is an assumption too strong. Luckily, this assumption can be easily relaxed which lead to M&M theory with tax. M&M theory with tax suggests: the value of the levered firm is equal to the value of the unlevered firm plus tax shield (VL = VU + TC*B).

Please explain why the value of tax shield = TC*B?

Hints: Start from the income statement. Use income statement to calculate the increase in annual cash flow because of the interest payment. And finally use perpetuity to valuation the tax shield.

Reference no: EM131559729

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