Advanced-this is not covered in the text but is covered in several introductory texts in finance
Merton Miller ["Debt and Taxes," Journal of Finance, 1977] extended the MM capital structure model to include both corporate and personal taxes, but not costs of financial distress. The value of the levered firm in Miller's world is
VL = VU + (1 - [(1 - TC)(1 - TS)/(1 - TB)]) B,
where
VL = the levered value of the firm (including the tax shields from debt)
VU = the unlevered value of the firm
B = market value of the firm's bonds
TC = firm's marginal tax rate
TS = the personal tax rate on stock (dividend and capital gain) income
TB = the personal tax rate on interest (bond) income
The rightmost term captures the increment to unlevered firm value from the tax shields on interest payments. Suppose corporate income tax rates are 0 percent, 18 percent, and 33 percent in Bermuda, Hong Kong, and the United Kingdom, respectively. Personal tax rates on interest income are 0 percent, 25 percent, and 40 percent, respectively. Individuals from each of these countries face effective tax rates on equity incomes of 0 percent, 0 percent, and 40 percent, respectively.
a. Use Miller's equation to find how much value the tax shield on a £100 million bond would add to the individuals in each of these three countries. Assume perpetual bonds and ignore costs of financial distress.
b. If these tax rates are faced by a majority of the residents in each country, in which country would you expect to find the most debt financing? In which country would you expect to find the most equity financing?