Suppose there are two firms with the same assets but different capital structures. Firm U uses no debt, while Firm L uses $100 debt, or 50% debt ratio. (See the blue-colored section of the balance sheets). Balance Sheet

	Firm U (Unlevered)	Firm L (Levered)
Current Assets	$100	$100
Fixed Assets	100	100
Total Assets	200	200
Debt (rd = 10% )	$ 0	$100
Common Stock	200	100
Total Liab and Equity	200	200

The following income statements are based on the assumption that these two firms are exactly the same in terms of their businesses; the same revenues ($100) and operating costs ($50). However, since Firm L uses debt ($10, r_d=10%) while Firm U does not, total income available to the capital contributors (= investors) are different for these two firms; $60 for Firm U and $64 for Firm L. More is available to the investors of Firm L than firm U. Income Statement

	Firm U (Unlevered)	Firm L (Levered)
Revenues	$150	$150
Operating Costs	50	50
Operating Income	$100	$100
Interest Expense	0	10
Taxable income	$100	$90
Taxes (T=40%)	40	36
After-tax Income	$ 60	$ 54
Add back interest	0	10
Income to investors	$ 60	$ 64

The above income statements show that extra $4 is available to the investors of Firm L compared to Firm U. Where does this extra $4 ( = 64 - 60) come from? The extra $4 is the tax savings. Interest payment of $10 creates the $4 tax savings for the firm. The calculation is as follows: The firm has $100 debt. ==> The firm pays $10 (=10% of $100) interest. ==> The firm's taxable income is reduced by $10, the same as the interest payment. ==> The firm's tax liabilities are reduced by $4 (=40% of $10).

Therefore, the annual tax savings can be found by the following formula: D x r_d x T, where D = debt, r_d = interest rate and T = tax rate.

(Annual) Tax Savings = Interest payment x Tax rate = Debt x Interest rate x Tax rate = D x r_d x T

For example, if a company borrows $10 million at the interest rate of 10% and the firm pays 40% tax, the annual tax savings would be $400,000 = $10m x (0.1) x (0.4). 3.4.2. Financial Risk versus Business Risk Let's now calculate the rate of return to stockholders for these two firms.

	Firm U(Unlevered)	Firm L(Levered)
Return on Equity (ROE)	$60 / $200 = 30%	$54 / $100 = 54%

#4 - Financial Risk Do you think 54% return for the levered firm's shareholders is better than 30% return for the unlevered shareholders? Why? Why not?