Question 4: A World With Tax

Based on M&M theory with no tax, capital structure doesn't matter due to homemade leverage. However, no tax is an assumption too strong. Luckily, this assumption can be easily relaxed which lead to M&M theory with tax. M&M theory with tax suggests: the value of the levered firm is equal to the value of the unlevered firm plus tax shield (V_L = V_U + T_C*B).

Please explain why the value of tax shield = T_C*B?

Hints: Start from the income statement. Use income statement to calculate the increase in annual cash flow because of the interest payment. And finally use perpetuity to valuation the tax shield.