Question

1. With corporate taxes as the only market imperfection, how does the value of the firm with leverage differ from its value without leverage? 2. How does leverage affect risk and return for investors? 3. What is the most important contribution of the Black-Scholes formula? 4. What are risk-neutral probabilities? How can they be used to value options?

Answer 1

1)

with corporate taxes as the only market imperfection,

let the tax rate = t

operating income of the firm = O

cost of capital for firm without leverage = r

let value of firm without leverage = v = [O*(1-t)/r]

amount of debt with the company = d

the value of firm with leverage = v+ (t*d)

hence in this case value of firm with leverage > value of firm without leverage