Modigliani and Miller show that accounting for corporate income taxes significantly changes the outcome of their capital structure analysis. Specifically, given a
firm’s investment policy, the tax deductibility of interest expense increases the market value of a levered firm…[Fill in the blank]

Question

BlackTom AI · Accepted Answer

With corporate taxes, interest is tax-deductible so debt creates a stream of tax savings (a tax shield). Modigliani–Miller with taxes therefore shows that a levered firm’s market value exceeds the unlevered value by the present value of those interest-tax savings — i.e., the interest tax shield.

1) Relevant concepts
- MM propositions (no-tax vs. with corporate taxes).
- Interest is deductible: taxable income = EBIT − Interest.
- Each dollar of interest reduces taxes by the corporate tax rate Tc, producing a tax shield of Tc × Interest.
- Present value (PV) of the stream of tax shields adds to firm value.

2) Step-by-step reasoning
- Let VU = value of the firm with no debt (all equity).
- With debt, each period interest I t reduces taxes by Tc · I t.
- The incremental value from debt = PV of those tax savings = Σ [Tc · I t / (1 + r) t] where r is appropriate discount rate.
- Thus VL = VU + PV(interest tax shield).

3) Intermediate calculations (perpetual constant debt case)
- If the firm maintains perpetual debt of face value D and interest rate rD so interest = rD·D each period, the annual tax saving = Tc·rD·D.
- Discounting a perpetual constant payment gives PV = (Tc·rD·D) / rD = Tc·D.
- So VL = VU + Tc·D (a common closed-form result).

4) Why the correct answer is correct
- The additional market value from leverage arises specifically from tax savings on interest payments — the interest tax shield — and so the increment equals the PV of that shield.

5) Why other options are incorrect
- b. Depreciation tax shield relates to non-debt tax deductions from depreciation (investment policy), not the incremental value from leverage.
- c. Present value of depreciation expense is not a tax saving per se; only depreciation’s tax effect (its tax shield) matters.
- d. Present value of tax liability is not the incremental benefit from taking on debt; debt lowers tax liabilities via interest deductions.
- e. Not applicable since (a) is correct.

6) Conclusion
Therefore the levered firm’s value increases by the present value of its interest tax shield, confirming answer (a).

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