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IAI Actuarial Core Principles · Business Finance · Personal and corporate taxation

Under the Modigliani-Miller propositions with corporate tax (and no other imperfections), the market value of a geared firm compared with an otherwise identical ungeared firm is:

With corporate tax, a geared firm is worth more than an identical ungeared firm by the present value of the interest tax shield, which for permanent debt equals the tax rate times the debt. Value is not unchanged and is not raised by total interest.

  1. ALower by the present value of the interest tax shield
  2. BEqual, because capital structure does not affect value
  3. CHigher by the present value of the interest tax shieldCorrect
  4. DLower, because gearing raises the weighted average cost of capital
  5. Higher by the total interest paid

Explanation

With tax, the geared firm's value equals the ungeared value plus the present value of tax savings on interest. For permanent debt D at tax rate t this is tD. Total interest is not the gain; only the tax saved is.

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