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 firm’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 firm’s value by including the effect of personal income taxes. He was interested in how the presence of individual income taxes would affect business’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 Miller’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 Miller’s work is the conclusion that the US Tax Code produces two competing pressures that affect a business’s use of leverage. These two conflicting effects are

• the deductibility of ________ which creates a tax shield—favors the use of ________ financing in a firm’s capital structure;
• the preferential tax treatment of ________ income (dividends and capital gains) favors the use of ________ financing.
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