2. (13 points) Assume that a firm pays taxes on revenue and is allowed some dedu

Question

2. (13 points) Assume that a firm pays taxes on revenue and is allowed some deductions. a. (3 points) Derive and explain the user cost of capital if the firm's nominal interest payments are tax deductible. b. (2 points) Derive and explain the user cost of capital if the firm's real interest payments are tax deductible. c. (3 points) Derive and explain the user cost of capital if the depreciation of capital is tax deductible. d. (2 points) Derive and explain the user cost of capital if the firm's real interest payments and the depreciation of capital are tax deductible. e. (3 points) What is the impact of the tax on the firm's desired level of capital in the last case?

Explanation / Answer

A - EBIT - interest = earning after interest - tax as applicable = Firm profit available to equity share holders

Lets suppose cost of capital of the firm = cost of debt =( interest / Market price of debt)*(1-tax rate) = after tax cost of debt

cost of equity = earning after interest and tax / market price of equity

So by the amount of interest Earnings would be reduced and tax would be charged on less amount of income so will reduce the cost of capital of the firm.

Operating profit - depreciation = EBIT - interest= earning after interest - tax = earning available to equity share holders.

If depreciation and interest both are tax deductable than firm cost of capital would be reduced by the amount of depreciation and interest and less tax would you need to pay.

Firm cost of capital would be reduced to the extent of tax saving due to depreciation and interest as both are tax dedcutable expense.

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