Which of the following statements is false? A. There is an important tax advantage to the use of debt financing B. Given a forecast of a future interest payment, we can determine the interest tax shield and compute its present value by discounting it at a rate that corresponds to its risk C. In a market that has taxes as the only market imperfection, if two firms are identical but differ only in their capital structure, then the value of the levered firm is higher than the value of the unlevered firm by the amount of interest tax shield D. To compute the increase in the firm’s total value associated with the interest tax shield, we need to forecast a firm’s debt and its interest payments
The Correct Answer and 1Explanation is:
The false statement is:
D. To compute the increase in the firm’s total value associated with the interest tax shield, we need to forecast a firm’s debt and its interest payments.
Explanation:
Let’s break down the statements:
A. There is an important tax advantage to the use of debt financing
This statement is true. Debt financing offers tax advantages because interest payments on debt are tax-deductible, reducing the firm’s taxable income and, consequently, the tax burden. This is known as the interest tax shield, which increases the firm’s value by reducing its overall taxes.
B. Given a forecast of a future interest payment, we can determine the interest tax shield and compute its present value by discounting it at a rate that corresponds to its risk
This statement is true. The interest tax shield arises from the tax deductibility of interest expenses. We can compute its present value by discounting the expected future tax shield (i.e., the tax benefit of interest payments) at a rate that reflects the risk of those future cash flows, typically the firm’s cost of debt.
C. In a market that has taxes as the only market imperfection, if two firms are identical but differ only in their capital structure, then the value of the levered firm is higher than the value of the unlevered firm by the amount of interest tax shield
This statement is true. This is essentially the Modigliani-Miller theorem with taxes, which suggests that in a world with taxes, the value of a levered firm is greater than the value of an unlevered firm by the present value of the tax shield on debt.
D. To compute the increase in the firm’s total value associated with the interest tax shield, we need to forecast a firm’s debt and its interest payments
This statement is false. While debt and interest payments are important for calculating the interest tax shield, the increase in the firm’s value due to the interest tax shield can be calculated without forecasting specific debt payments. The value of the interest tax shield is the present value of the future tax shield benefits, which can be calculated using the firm’s existing or expected debt level and applying the appropriate tax rate. This does not necessarily require a detailed forecast of the debt structure over time, especially for simplified models.
In summary, statement D is false because the calculation of the interest tax shield’s impact on firm value doesn’t require detailed forecasting of future debt payments. Instead, it can be estimated based on current debt levels and tax rates.
