Question

One of the conditions that the Modigliani and Miller (M&M) Propositions required was for there to be no tax. Discuss i) whether the introduction of tax decreases or increases the value of the company, ii) how much is the increase or decrease expected to be and iii) why this happens.

Answer 1

As per Modigilani Approach Preposition I (With No Taxes), value of the enterprise does not depend on the capital structure of the firm. This preposition assumes no tax environment. The approach assumes that any reduction on cost of debt, in turn increases the cost of equity such that overall cost of capital is unchanged thereby the value of the firm is unchanged.

Cost of Levered Equity = Cost of Unlevered Equity + Debt / Equity (Cost of un-levered equity - Cost of Debt)

Under the Modigilani Approach Preposition I (With Taxes), the value of the firm will increase if the tax picture is considered. Hence value of firm will only increase by the tax portion of debt. The second preposition states that, the cost of equity has a direct relation with the level of debt. As level of debt increases, the default risk increases so does the cost of equity. However, it should be noted that the tax shield available due to taxes makes it less sensitive to changes in level of debt.

Cost of Levered Equity = Cost of Unlevered Equity + Debt (1- Tax)  / Equity (Cost of unlevered equity - Cost of Debt)

Hence we observe that introduction of tax in the working reduces the overall cost of capital of the company.

Value of the firm increases by the amount the debt availed on whose interest tax is deductible. Hence value of firm increases by Debt * Tax Rate