(^278) Financial Management
In case of the levered firm, the shareholderís earnings will be:
(X - kdD)(l - T)(1 - Tpe) ...(21)
and the debt-holdersí earnings after personal taxes at a rate equal to Tpb Will be:
kdD(1 - Tpb) ...(22)
The total income of both types of investors (shareholders and debt-holders) will be:
(
X
- kdD)(l - T)(1 - Tpe) +kdD(1 - Tpb)
X(1 - T)(1 - Tpe) - kdD(1 - T)(1 - Tpe) + kdD(1 - Tpb) ...(23)
Note that the first term of Equation (23) is equal to the shareholderís earnings of an
unlevered firm and therefore, it can be discounted at k. The remaining terms have the
Same risk as the interest payments, and therefore, they can be discounted at k,(l - Tpb).
Thus the value of the levered firm is:
-
- =
- = + - ...(24)
The second term of Equation (24) is the gain from leverage (viz. the present value of
the interest tax shield):PVINTS
- = - ...(25)
Applying Equation (25) to data in Table 18.8, we obtain:PVINTS ^ ^
^
^ ^ ^ =
= -
- = - - -
and when applied to data of Table we obtain:PVINTS = ^
^ ^
^ ^ ^ =
= -
- = - - -
We can generalise the following from Equation (25)
l If Tpe = Tpb = 0, then the present value of the interest tax shield is equal to: TD
(corporate tax rate T times the amount of debt, D).
l If Tpb > Tpe which is a reasonable assumption given the personal tax laws in
India, then the present value of the interest tax shield will be less than TD:
PVINTS < TD.
l If (1 - Tpb) = (1-T) (1 - Tpe), then the advantageous of leverage will be completely
lost.