Levered vs. Unlevered firm

[the show NY]

“The value of a levered firm is equal to the value of an unlevered firm plus the tax shield.”
I do understand that using debt provides a tax shield because interest is tax deductible. However, I still don’t understand how this is better than using all equity. The tax shield will “mitigate” the cost of your debt, meaning that if say you borrow at 5% the true cost to your bottom line will be lower due to the tax benefits. But if you used no debt at all, then you’d have no interested payments. So to me it seems that using debt that is not tax deductible is the worst, debt that is tax deductible is better, and all equity is best because there are no interest payments to deduct.
What am i missing here? Thanks.

 

[xck2000]

the show NY Wrote:
——————————————————-
> “The value of a levered firm is equal to the value
> of an unlevered firm plus the tax shield.”
>
> I do understand that using debt provides a tax
> shield because interest is tax deductible.
> However, I still don’t understand how this is
> better than using all equity. The tax shield will
> “mitigate” the cost of your debt, meaning that if
> say you borrow at 5% the true cost to your bottom
> line will be lower due to the tax benefits. But
> if you used no debt at all, then you’d have no
> interested payments. So to me it seems that using
> debt that is not tax deductible is the worst, debt
> that is tax deductible is better, and all equity
> is best because there are no interest payments to
> deduct.
>
> What am i missing here? Thanks.
using all equity doesn’t provide you that tax shield. say if rates is 10% equity, and debt is 10%, you would prefer debt because the cost of debt would really be 10%(1-Tax)
there is still a required rate of return for equity. no matter what, money comes at a cost. And yes tax that is not tax deductible is worst… but i think that is classified as preferred dividends and equity.

 

[Dreary]

The value of a firm is the present value of all futre cash flows discounted by the required rate of return. The smaller the required rate of return the higher the value. So, if you use equity only, the required rate of return is high, thus a lower value. The more debt you have the higher the value because of theh tax shield, i.e., cost of debt is cheaper than anything else. So, if you subscribe to MM, then you should have all debt in your capital structure.
However, the problem is that more debt puts financial stress on the company, which raises the required rate of return on equity (equity providers start wanting higher rate to offset the increased risk). So, you have to somewhoe balance the two to get to the optimal required rate. Even if you pay interest on debt, it is stil cheaper than getting money from equity holders who get to share in the profits with you. The debt guys only get their fixed interest and they go away, that’s what’s nice about them.

 

[the show NY]

great help from both of you, thanks. i think the part i was not conceptualizing before was xck2000’s line: “there is still a required rate of return for equity. no matter what, money comes at a cost. ”
i had assumed that equity capital was “free” while an interest had to be paid for for debt. but this makes sense now, as it is obvious that debt is better because not only is the required return less but it’s also tax deductible.
thanks!