How Can the Common Practice of Using a Firm's Overall

question 8

Multiple Choice

How can the common practice of using a firm's overall cost of capital rather than its cost of debt as a discount rate when calculating the present value of tax savings be justified?

• A)The debt policy of the firm will cause the amount of its tax shelter to increase as the firm grows larger and the firm borrows more debt. Thus, the tax shelter will grow as firm
• Value increases.
• B)Because tax savings are usually relatively small, the difference in the discount rate used doesn't make a large difference in the present value.
• C)It is never justifiable; tax savings should always be discounted using the firm's cost of debt since these cash flows are in the same risk category as the firm's debt cash flows.
• D)Both A and B are legitimate justifications.

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Definitions:

Working Capital

The gap between an enterprise's immediate assets and liabilities, showcasing the available liquidity for its daily activities.

Pretax Return

The income generated from an investment before the deduction of any taxes.

Sales Revenues

The total income generated from the sale of goods and services by a company before any costs or expenses are deducted.

Cash Operating Expenses

Expenses incurred during the operational activities of a business that affect cash flow, such as paying salaries and purchasing materials.