Taxes, Interest Expense, and Firm Value example

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Taxes, Interest Expense, and Firm Value


Taxes are potentially an important consideration in a firm’s financing decisions (Fama & French, 1998). The most controversial and significant determinants of behavior investors in the markets, the level of taxation is income investors. Works by Robert Litzenberger and Krishna Ramaswamy initiated the theory of tax differentiation, according to which from the perspective of shareholders the major priority have capitalized income rather than dividend yield, as income from the capitalization is taxed at a lower rate than the income received in the form of dividends. If the tax rate on dividends more than the tax rate on capital gains, investors require increased the profitability of investments in shares of companies that pay dividends, resulting in relatively lower prices of shares of companies that pay dividends. Thus, firms become not profitable to pay high dividends. The importance of the theory of tax differentiation is confirmed by the authorities' attention to the level of taxation of dividend payments.

Interest Expense

According to S. Gervais interest expenses are tax deductible, the value of the firm would tend to upsurge as debt is added to the capital structure, but there would be an offset in the form of the increasing cost of bankruptcy. The interest expenses are identical to the pre-tax cost of debt increased by the market value of debt. If a firm has deep-rooted debt, with interest expenses that are diverse from this value, the two methods will deviate. The interest expense of the typical firm is well below its taxable income, suggesting that firms do not fully feat the tax compensations of debt.


Fama, E. F., & French, K. R.. (1998). Taxes, Financing Decisions, and Firm Value. The Journal of Finance, 53(3), 819–843. Retrieved from

S. Garvais (2011). Finance 351 – Corporate Finance. Problem Set #7, p. 3.Retrieved from Download Full Essay Show full preview


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