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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

Under Modigliani and Miller's proposition with corporate taxes, how does the value of a geared firm compare with an otherwise identical ungeared firm, assuming permanent debt and no other market imperfections?

The geared firm is worth more than the ungeared firm by debt multiplied by the corporate tax rate. This is the present value of the permanent interest tax shield, so with taxes Vg equals Vu plus tD.

  1. AIt is lower by the present value of the interest tax shield
  2. BIt is higher by the debt value multiplied by the corporate tax rateCorrect
  3. CIt is the same because capital structure is irrelevant
  4. DIt is higher by the full amount of the debt raised
  5. It is lower because the cost of equity rises by more than the tax saving

Explanation

With permanent debt D and tax rate t, the tax shield has present value tD. So Vg = Vu + tD. Option 3 is the no-tax result.

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