7. The effect of taxes

Modgliani and Miller Proposition I with Taxes

Debt financing has one important advantage that the early Modigliani and Miller (MM) propositions ignored: the interest on business debt is tax deductible. This benefit means that the amount of taxes that a business is required to pay will be reduced by a phenomenon called an interest tax shield, which is a function of the amount of debt in the firms capital structure and its tax rate. In contrast, the dividends that a corporation pays on its common and preferred shares are not tax deductible.

Consider the case of Orange Goose Foodstuffs, Inc.:

At the beginning of the year, Orange Goose Foodstuffs, Inc. had an unlevered value of $9,000,000. It pays federal and state taxes at the marginal rate of 40%, and currently has $3,000,000 in debt capital in its capital structure.

According to MM Proposition I with taxes, Orange Goose Foodstuffs is allowed to recognize a tax shield of ($1,680,000 or $2,640,000 or $1,200,000 or $1,920,000) , and the levered value of the firm is:

$10,200,000.

$7,800,000.

$12,000,000.

$6,000,000

. 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.