In a world with corporate taxes (only capital markets imperfection), a levered firm will issue equity to repay some of its debt.

Indicate which of the following statements is correct:

Question

In a world with corporate taxes (only capital markets imperfection), a levered firm will issue equity to repay some of its debt.

Indicate which of the following statements is correct:

BlackTom AI · Accepted Answer

Question restatement: In a world with corporate taxes (and only capital market imperfections), a levered firm will issue equity to repay some of its debt. Which statement is correct?

Option 1: The transaction will decrease the firm’s equity beta and cost of equity, but it will increase its WACC.
- Analysis: Reducing leverage by replacing debt with equity tends to reduce the financial risk borne by equity holders, which can lower the equity beta and cost of equity. However, removing debt also reduces the interest tax shield that levered firms enjoy, which tends to raise the after-tax cost of financing overall. The effect on WACC depends on the balance between a lower cost of equity and the loss of the debt tax shield. In a setting with taxes, shedding debt generally reduces the tax shield benefit, which tends to push WACC upward rather than downward, not consistently upward only; but claiming that WACC will increase is plausible. Yet the option asserts WACC increases while also stating the cost of equity decreases; the combined claim is not inherently inconsistent, but the line about WACC increasing is not the most direct or complete characterization and the statement also asserts a decrease in equity beta, which is typically true, but the overall WACC claim makes this option less clean as a standalone correct statement.

Option 2: The transaction will reduce the value of the firm’s interest tax shields and thus its WACC.
- Analysis: When a levered firm reduces debt by issuing equity to repay debt, the total value of tax shields from debt falls, because the debt component shrinks. The after-tax cost of debt term in WACC is rd(1−Tc), multiplied by the debt ratio; with less debt, the total tax-advantaged shield declines, which tends to push WACC upward (since you lose tax savings). The statement correctly identifies the direct consequence: the value of the interest tax shields decreases, and that reduction affects WACC. Although it doesn’t spell out the direction of WACC explicitly (it says “and thus its WACC”), the linkage from fewer tax shields to a higher WACC is the standard implication in a tax-only world. This option aligns with the basic Modigliani–Miller with taxes intuition in a simple capital-market setting.

Option 3: The transaction will increase the firm’s value and equity value, and it will also increase its WACC.
- Analysis: Reducing debt typically reduces the present value of the tax shield, which lowers firm value, not increases it. Therefore, this option contradicts the standard result: a levered firm benefits from debt via tax shields, so repaying debt reduces the tax shield value and overall firm value, all else equal. The claim that both firm value and equity value rise is inconsistent with lowering leverage and losing debt tax shields.

Option 4: The transaction will reduce firm value and increase both the cost of debt and the cost of equity.
- Analysis: When debt is repaid and leverage declines, the firm loses the tax shield, which would tend to decrease firm value. However, the cost of debt would not increase because debt is being reduced; in fact, the firm has less debt, so the cost of debt observable at the market level could become less relevant. The cost of equity may rise due to higher financial risk from less debt relief, but the assertion that both costs rise is not clearly supported by the standard tax-only framework, where reducing leverage reduces financial distress risk and can lower the cost of debt exposure in the overall WACC calculation. This option misstates the likely impact on costs and value.

Putting the pieces together, each option presents a different narrative about how cutting debt via equity affects tax shields, WACC, and value. The key mechanism is that debt provides a tax shield; reducing debt shrinks that shield, lowering the tax-advantaged benefit and generally pushing WACC upward and firm value downward in a pure tax framework. The most accurate linkage among the effects described is that the reduction in debt reduces the value of interest tax shields, which in turn affects WACC in the direction consistent with a higher WACC due to fewer tax benefits.

In a world with corporate taxes (only capital markets imperfection), a levered firm will issue equity to repay some of its debt. Indicate which of the following statements is correct:Single choice

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