You are considering a firm under three separate scenarios: 1) no debt, taxes or bankruptcy costs,...

You are considering a firm under three separate scenarios: 1) no debt, taxes or bankruptcy costs, 2) with debt and taxes but no bankruptcy costs, and 3) with debt, taxes, and bankruptcy costs. Under which one of these three scenarios will the firm have the highest value? Please explain why. (7 points)

Expert Solution

When there is no debt, no bankruptcy cost and no taxes in such scenario ,the profit earned by the company is completely distributed to the shareholders. it is not to be deducted either by taxes or by any kind of interest costs.

When there is a debt free company in a tax free world, the value of the company automatically maximizes as there are no cost related to financing that are involved in the form of interest and there are no taxes as well to be paid out of earnings so the earnings are maximized to the optimum extent and shareholders values are also maximized leading to maximization in overall market capitalisation of the company.

Show under scenario 1 the value of the company with would be maximized out of all 3 scenarios.

Taxes reduce the earning of a company and interest charges also reduce the earning of the company so debt free company in a tax free world is more poised to maximize its overall market capitalisation and overall value.

jeff jeffy answered 2 years ago

Bankruptcy costs are a disincentive to debt financing.

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