When corporate income taxes and personal taxes on interest income are considered, the general expression for the value of a levered firm in a world in which the tax rate on equity distribution equals zero is:

VL =VU +{1[(1TC)/(1TB)]}B

Where: VL = Value of a levered firm VU = Value of an unlevered firm B = Value of the firms debt TC = Tax rate on corporate income TB = Personal tax rate on interest income

In their propositions I and II, what do Modigliani and Miller assume about TC and TB ? What do these assumptions imply about the optimal debt ratio? Support your answers with relevant algebra.

If the corporate tax rate is 25% and the personal tax rate on interest income is 20%, by how much will the value of the firm change if it issues 1 million in debt and uses the proceeds to repurchase equity? Explain your calculations carefully.

Rewrite the equation for the levered firm with the addition of the costs of financial distress. How would your answer to part (d) change in the presence of the costs of financial distress? Explain your answer carefully and give your suggestion regarding the companys capital structure.