Question

M&M Theory on Capital Structure has three stages in its development which assumes 1) no taxes, 2) only corporate taxes are allowed, and 3) both personal and corporate taxes are allowed (Miller’s model). Assume Tc = corporate tax rate, Td = personal tax rate on debt income, Ts = personal tax rate on stock income. If Tc= 45%, Td = 25%, and Ts = 15%, what is the value of a Levered Firm vs. the value of Unlevered Firm based on Miller’s model? What does it indicate to the manager with regard to financial leverage

Answer 1

Tc= 45%, Td = 25%, and Ts = 15%

1. MM theory with no taxes :

An investor is indifferent to raise capital for the company either through only equity or through debt-equity mix as there are no taxes associated with the debt.

2. When only corporate taxed are allowed:

Vl = Vu + 0.45D

3. When Personal and corporate taxes are allowed

Vl = Vu + ((1-0.45) (1-0.15))/(1-0.25) D

Vl = Vu + 0.62D

Interpretation: The value of the firm increases with the increase in debt used to finance the capital of the company. As higher the leverage, higher will be the tax shield and the higher will be the value of the company.

Leverage is increased in the case when both the taxes were allowed as compared to when only corporate taxes were allowed.

As higher the value of the company, the higher will be the return on equity. Due to this, the manager would be more beneficial as he can raise capital at a cheap rate of interest and also generate higher returns on equity by paying lower taxes.