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Discuss the finding of Modigliani and Miller in a world with taxes in regards to the...

Discuss the finding of Modigliani and Miller in a world with taxes in regards to the value of levered and unlevered firms. What do these finding imply about the effects of capital structure? The effects of investment decisions? The cost of capital?

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Expert Solution

Modigliani and Miller approach have an assumption that there are no taxes. But, in the real world taxes do exist. This theory recognizes the tax benefits due to the the interest payments.

Unlevered firms when considers the component of debt in its capital structure are tax benefited by the payment of interest. An increase amount of debt will make the unleverage company leverage. So, a company can apply debt as long as a threshold limit is reached. Thus,

VL = VU + TcD

VL = Value of the leveraged firm

Vu = Value of the unleveraged firm

TCD is the value of tax rate (TC) * Debt(D)

Thus, levered firms have an advantage over unlevered firms as taxes are lowered due to interest payments. This may not be in the case of equity as no tax benefits on dividend payments.

Levered should increase the debt in the firm's capital structure to a threshold limit. It is advantageous to increase the debt-to-equity ratio due to tax shields.

The investment decisions are effected with the existence of taxes and company will go for more and more debt.

This theory also lowers the cost of capital as taxes are lowered by using more debts as compared to equity with no tax benefits on dividends. in this theory, equities are replaced by cheap debts which ultimately lowers the company's Weighted Average Cost of Capital (WACC).

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