position 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 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 Red Dolphin Foodstuffs, Inc.: At the beginning of the year, Red Dolphin Foodstuffs, Inc. had an unlevered value of $10,000,000. It pays federal and state taxes at the marginal rate of 35%, and currently has $3,000,000 in debt capital in its capital structure. According to MM Proposition with taxes, Red Dolphin Foodstuffs is allowed to recognize a tax shield of the firm is and the levered value of O $13,000,000 $11,050,000 O $7,000,000 $8.950,000 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 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: V1 = V. +D/I - -T-T) -T2 where T., T., and Ta represent the tax rates imposed on corporate income, personal income from equity Investments, and personal income from investments, respectively, pre-tax return on equity A basic premise of Miller's work, under the current US Tax Code, is that investors are willing to accept a 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 Miller's work is the conclusion that the US Tax Code produces two competing pressures that affect a business's use of leverage. The two conflicting effects are the deductibility of the preferential tax treatment of --which creates a tax shield--favors the use of financing in a firm's capital structure; income (dividends and capital gains) favors the use of financing