Debt financing has one important advantage that the early Modigliani and Miller (MM) propositions ignored: the interest on business debt is tax deductible. This benefit means that the amount of taxes that a business is required to pay will be reduced by a phenomenon called an interest tax shield, which is a function of the amount of debt in the firmĂ˘â‚¬â„˘s capital structure and its tax rate. In contrast, the dividends that a corporation pays on its common and preferred shares are not tax deductible.
Consider the case of Blue Chipmunk Foodstuffs, Inc.:
At the beginning of the year, Blue Chipmunk Foodstuffs, Inc. had an unlevered value of $9,000,000. It pays federal and state taxes at the marginal rate of 40%, and currently has $3,000,000 in debt capital in its capital structure.
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According to MM Proposition I with taxes, Blue Chipmunk Foodstuffs is allowed to recognize a tax shield of ________ , and the levered value of the firm is
In 1977, Merton Miller added to the discussion regarding the effect of taxes on a firmĂ˘â‚¬â„˘s value by including the effect of personal income taxes. He was interested in how the presence of individual income taxes would affect businessĂ˘â‚¬â„˘s use of debt financing, and developed the following model for the value of a levered firm:
|VLVL||= =||Vu+D [1-(1-Tc)(1-Ts)(1-Td)],Vu+D [1-1-Tc?1-Ts1-Td],|
where TcTc, TsTs, and TdTd represent the tax rates imposed on corporate income, personal income from equity investments, and personal income from debt investments, respectively.
A basic premise of MillerĂ˘â‚¬â„˘s work, under the current US Tax Code, is that investors are willing to accept a ________ pre-tax return on equity investments than on bond investments because tax rates imposed on
– bond investments are lower than those imposed on equity investments.
– equity investments are lower than those imposed on bond investments.
The result of MillerĂ˘â‚¬â„˘s work is the conclusion that the US Tax Code produces two competing pressures that affect a businessĂ˘â‚¬â„˘s use of leverage. These two conflicting effects are
|Ă˘â‚¬Â˘||the deductibility of ________ which creates a tax shieldĂ˘â‚¬â€ťfavors the use of ________ financing in a firmĂ˘â‚¬â„˘s capital structure;|
|Ă˘â‚¬Â˘||the preferential tax treatment of ________ income (dividends and capital gains) favors the use of ________ financing.|