In: Finance
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
Modigliani Miller Proposition with no taxes said that the value of the firm is independent of its capital structure.
i) The introduction of tax increases the value of the firm provided it has debt outstanding and firm value is directly proportional to the leverage.
ii) The value of levered firm is given as under
Value of firm levered = Value of firm unlevered + (tax rate*Amount of debt)
Thus, the value of firm increases by the amount of tax rate times amount of debt. In a world with no bankruptcy costs, capital structure thus should be completely composed of debt.
iii) This happens as companies get tax advantages due to debt. Interest payments are deducted before calculating taxes. This, reduces tax liabilities and thus adds value for the firm. This is called tax shield. The reduction in taxes each year is (tax rate*interest rate*amount borrowed). Considering perpetual savings of this amount, the present value comes out as (tax rate*interest rate*amount borrowed/interest rate) = tax rate * amount borrowed.
Thus, value of levered firm increases (ignoring bankruptcy costs).