Which of the following statements is FALSE? I) Given a forecast of future interest payments, we can determine the interest tax shield and compute its present value by discounting it at a rate that corresponds to its risk. II) The total value of the unlevered firm exceeds the value of the firm with leverage due to the present value of the tax savings from debt. III) By increasing the amount paid to debt holders through interest payments, the amount of the pre-tax cash flows that must be paid as taxes increases. IV) There is an important tax advantage to the use of debt financing.
The Correct Answer and Explanation is :
The FALSE statement among the ones provided is:
III) By increasing the amount paid to debt holders through interest payments, the amount of the pre-tax cash flows that must be paid as taxes increases.
Explanation:
Let’s go through each statement:
I) Given a forecast of future interest payments, we can determine the interest tax shield and compute its present value by discounting it at a rate that corresponds to its risk.
- True: The interest tax shield refers to the tax savings a company receives from the interest payments on its debt. Since interest payments are tax-deductible, the present value of these tax savings can be computed by discounting future interest tax shields using a rate that reflects the risk of the debt.
II) The total value of the unlevered firm exceeds the value of the firm with leverage due to the present value of the tax savings from debt.
- False: This statement is actually incorrect because the total value of the leveraged firm is typically higher than that of the unlevered firm, due to the tax savings from debt. This phenomenon is a fundamental principle in corporate finance known as the tax shield effect. When a firm uses debt financing, the interest payments reduce taxable income, thereby saving taxes, which increases the firm’s value. Therefore, the unlevered firm’s value is generally lower than that of a leveraged firm, assuming other factors are constant.
III) By increasing the amount paid to debt holders through interest payments, the amount of the pre-tax cash flows that must be paid as taxes increases.
- False: This statement is incorrect. Increasing interest payments actually reduces the pre-tax cash flows that are taxable. Since interest expenses are tax-deductible, increasing the interest payments reduces the taxable income, thereby reducing the amount of taxes a firm has to pay. In other words, more interest payments lead to lower taxes, not higher.
IV) There is an important tax advantage to the use of debt financing.
- True: The use of debt financing offers a tax advantage because interest payments on debt are tax-deductible. This reduces the firm’s taxable income and thus the tax liability, providing a valuable tax shield.
Conclusion:
The incorrect statement is III, as it falsely implies that increasing interest payments increases the taxes owed, when in fact, it reduces the taxable income and the tax burden.