5 In a world with corporate taxes but no bankruptcy costs, firm value is an increasing function of leverage.

The formula for the value of the firm is V L  =  V U  +  t C D Expected return on levered equity can be expressed as R E  =  R A  +  ( 1 −  t c )  ×  ( R A  −  R D )  × 

D __ E

Here, value is positively related to leverage. This result implies that firms should have a capital structure almost entirely composed of debt. Because real-world firms select more moderate levels of debt, Chapter 19 considers modifications to the results of this chapter.

6 If distributions to shareholders are taxed at a lower effective personal tax rate than are interest payments, the tax advantage to debt at the corporate level is partially offset.