Multiple Choice
Which of the following best describes the Capital Market Line (CML) in the context of investments in securities?
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7. Receivables and Investments
Introduction to Investments in Securities
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An increase in a levered firm's tax rate will:
A
Increase the value of the interest tax shield, thereby increasing the firm's value.
B
Reduce the firm's cost of equity.
C
Decrease the value of the interest tax shield, thereby decreasing the firm's value.
D
Have no effect on the value of the interest tax shield.
Verified step by step guidance1
Understand the concept of the interest tax shield: The interest tax shield refers to the reduction in taxable income due to the deduction of interest expenses. This is a benefit for levered firms (firms with debt) because interest payments are tax-deductible.
Recognize the relationship between the tax rate and the interest tax shield: The value of the interest tax shield is calculated as the product of the tax rate and the interest expense. Mathematically, it can be expressed as: .
Analyze the impact of an increase in the tax rate: If the tax rate increases, the value of the interest tax shield will also increase because the tax rate is directly proportional to the interest tax shield. This means the firm saves more on taxes due to the deductibility of interest expenses.
Connect the increase in the interest tax shield to the firm's value: Since the interest tax shield represents a tax saving, an increase in its value enhances the overall value of the firm. This is because the firm retains more cash flow due to reduced tax liability.
Evaluate the other options provided in the problem: The increase in the tax rate does not reduce the firm's cost of equity, nor does it decrease the value of the interest tax shield. It also does not leave the interest tax shield unaffected. Therefore, the correct interpretation is that an increase in the tax rate increases the value of the interest tax shield, thereby increasing the firm's value.
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