7. The effect of taxes

Modgliani and Miller Proposition I with Taxes

. In 1977, Merton Miller added to the discussion regarding the effect of taxes on a firms value by including the effect of personal income taxes.

He was interested in how the presence of individual income taxes would affect businesss use of debt financing, and developed the following model for the value of a levered firm:

VL = Vu+D [1(1Tc)(1Ts)(1Td)],

where Tc, Ts, and Td represent the tax rates imposed on corporate income, personal income from equity investments, and personal income from debt investments, respectively.

A basic premise of Millers work, under the current US Tax Code, is that investors are willing to accept a (Lower or Higher) _pre-tax return on equity investments than on bond investments because tax rates imposed on:

?equity investments are lower than those imposed on bond investments.

?bond investments are lower than those imposed on equity investments.

The result of Millers work is the conclusion that the US Tax Code produces two competing pressures that affect a businesss use of leverage.

These two conflicting effects are

the deductibility of (Dividends/interest) which creates a tax shieldfavors the use of (Debt /Equity) financing in a firms capital structure;

the preferential tax treatment of (Debt/Equity) income (dividends and capital gains) favors the use of (Equity/Debt) financing.