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Modgliani and Miller Proposition I with Taxes Debt financing has one important advantage that the early Modiglianl 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 firm's 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 Yellow Dragon Foodstuffs, Inc: : At the beginning of the year, Yellow Dragon 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 1 with taxes, Yellow Dragon Foodstuffs is allowed to recognize a tax shield of the firm is , and the levered value of $12,000,000.$6,000,000.$7,800,000.$10,200,000. In 1977, Merton Miller added to the discussion regarding the effect of taxes on a firm's value by including the effect of personal income taxes, He was interested in how the presence of individual income taxes would affect business's use of debt financing, and developed the following model for the value of a levered firm: VC=Vu+D[1(1T4}(dIu(dTi)] In 1977, Merton Miller added to the discussion regarding the effect of taxes on a firm's value by including the effect of personal income tares He was Interested in how the presence of individuat income taxes would affect business's use of debt financing, and developed the following modet for the value of a levered firm: Where Tt,T1, and Td represent the tax rates inposed on corporate income, personal income from equity investments, and personal income from debt invesments, respectively. A basic premise of Milier's work, under the current us Tax Cede, is that investors are wiling to pr a ot a pre-tax return on equity investments than on bond investments because tax rates imposed on equity investments are lower than thote imposed on bond investments. bond investments are lower than those imposed on equity investments. The result of Miller's work is the conclusion that the US Tax Cede produces two competing peessures that affect a business's use of leverage. These two canflicting effects are - the deductibility of -which creates a tax shield-favors the use of finaneing in a firms capital structure: - the preferential tax treatment of income (dividends and capital gains) favars the use of financing