Chapter 15
Debt and Taxes
I. Chapter Outline
The following chapter outline is correlated to the PowerPoint Lecture Slides. The PowerPoint slides
are referenced in bold. Alternative Examples to selected textbook examples are also available in the
PowerPoint Lecture Slides and are also referenced in bold.
15.1 The Interest Tax Deduction (Slides 6–11)
• Table 15.1 Macy’s Income with and without Leverage, Fiscal Year 2014 ($ million)
15.2 Valuing the Interest Tax Shield (Slide 16)
• The Interest Tax Shield and Firm Value (Slides 17, 19)
• Figure 15.1 The Cash Flows of the Unlevered and Levered Firm (Slide 18)
• Example 15.2 Valuing the Interest Tax Shield without Risk (Slides 20–21)
• PowerPoint Alternative Example 15.2 (Slides 22–23)
• The Interest Tax Shield with Permanent Debt (Slides 24–27)
• The Weighted Average Cost of Capital with Taxes (Slide 28)
• PowerPoint Alternative Example 15.3 (Slides 34–38)
15.3 Recapitalizing to Capture the Tax Shield (Slide 39)
• The Tax Benefit (Slides 40–42)
• The Share Repurchase (Slides 43-45)
• No Arbitrage Pricing (Slides 46–49)
• Example 15.4 Alternative Repurchase Prices (Slides 50–51)
• PowerPoint Alternative Example 15.4 (Slides 52–53)
15.4 Personal Taxes (Slides 56–57)
• Including Personal Taxes in the Interest Tax Shield (Slides 58–59, 61-63)
• Figure 15.3 After-Tax Investor Cash Flows Resulting from $1 in EBIT (Slide 60)
• Table 15.3 Top Federal Tax Rates in the United States, 1971–2015 (Slide 61)
64 Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition
• Example 15.5 Calculating the Effective Tax Advantage of Debt (Slides 64–65)
• PowerPoint Alternative Example 15.5 (Slides 66–67)
• Figure 15.4 The Effective Tax Advantage of Debt with and without Personal Taxes,
1971–2015 (Slide 68)
15.5 Optimal Capital Structure with Taxes (Slide 83)
• Do Firms Prefer Debt? (Slides 83, 85, 87)
• Figure 15.5 Net External Financing and Capital Expenditures by U.S. Corporations
(1975–2014) (Slide 84)
• Figure 15.6 Debt-to–Value Ratio (D/(E + D) of U.S. Firms, 1975–2014 (Slide 86)
• Figure 15.7 Debt-to–Value Ratio (D/(E + D) for Select Industries (2015) (Slides 88-89)
• Limits to the Tax Benefit of Debt (Slides 90–96, 98)
• Table 15.4 Tax Savings with Different Amounts of Leverage (Slide 91)
• Figure 15.8 Tax Savings for Different Levels of Interest (Slide 97)
II. Learning Objectives
15-1 Explain the effect of interest payments on cash flows to investors.
15-3 Calculate the value of a levered firm.
15-5 Describe the effect of a leveraged recapitalization on the value of equity.
15-7 Given corporate and personal tax rates on equity and debt, calculate the tax benefit of debt
with personal taxes.
15-9 Describe the relationship between the optimal fraction of debt and the growth rate of the firm.
Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition 65
III. Chapter Overview
The motivation for this chapter is empirical observation of corporate capital structure. In particular, if
capital structure is unimportant, why do we see consistent differences in capital structure across firms
and industries? Also, why do managers spend time thinking about capital structure if it is irrelevant?
15.1 The Interest Tax Deduction
15.2 Valuing the Interest Tax Shield
This section of the chapter shows how to calculate the value of the levered firm. Equation 15.2 is a
15.3 Recapitalizing to Capture the Tax Shield
The authors first compute the value of the levered firm, then subtract the debt value to show the new
value of equity. If the stock is repurchased at its pre-recapitalization rate, then the stock price will
15.4 Personal Taxes
This section includes the consequences of the combination of personal and corporate taxes. Table
15.3 shows top federal tax rates in the United States during the last 34 years. Figure 15.3 is a visual
aid to understanding how taxes are paid, so that equation 15.7, showing the effective tax advantage of
15.5 Optimal Capital Structure with Taxes
Figure 15.5 shows net external financing and capital expenditures by U.S. Corporations from 1975–
2014. This chart indicates that most companies raise external capital using debt. However, market
value of equity continues to increase as firms retain earnings so that the market value debt to equity
ratio is about 36% on average. Figure 15.7 shows debt as a fraction of firm value by industry and for
the market. It is clear that there are large differences across industries.
66 Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition
that exceed EBIT are discussed in Chapter 16. When EBIT is uncertain, the tax savings declines for
high levels of interest, as shown in Figure 15.8.
Growth will affect the optimal leverage ratio, even for firms with positive earnings. The higher
the firm’s growth rate, the lower will be the optimal proportion of debt in the capital structure. In
addition, when firms have other tax shields, taxable earnings will be reduced without incurring
interest payments.
IV. Spreadsheet Solutions in Excel
The following Problems for Chapter 15 have spreadsheet versions of the problems available: 4, 5, 7,
and 27.
These spreadsheets can be downloaded from the Instructor’s Resource Center at: