Abstract

The optimal capital structure of a certain firm is the relative proportion of equity and debt financing which
maximizes the value of the firm. The method of financing has a direct effect on the total value of the firm.
In a world with no taxes, the value of a firm is independent of the relative proportion of equity and debt
financing. In the world with taxes, leverage can increase the value of the firm considering the tax
deductibility of interest payments. This can further be described as the tax shield provided by payments.
However, taxes are applied to both corporate income and personal income in the real world. The rate of
tax on stock income can differ from those on bond income. The effective tax rates of different firms can
either be identical or different which could affect the optimal level and benefit of leverage. The aim of our
study was to screen varying capital structures and tax rates, to determine the effect they have on the
value of the firm and value enhancement of different capital suppliers. In the scenario where the effective
tax rate for firms is identical, the gain from leverage is lower if the tax rate on common stock is less than
on bonds. If the tax rate on common stock and bond income is similar, the gain from leverage is identical
to the one obtained in the world with just personal taxes. In a world where corporations can be charged
different effective tax rates, the firms will have a certain level of debt on its balance sheet and this tax
shield declines in value as more and more debt is used.