IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects
Under the Modigliani-Miller propositions with corporate tax, if a firm replaces some equity with debt, what happens to its WACC and value, other things equal and ignoring distress costs?
WACC falls and firm value rises. Under Modigliani-Miller with corporate tax, interest is tax deductible, so more debt adds a tax shield that lowers WACC and increases value when distress costs are ignored.
- AWACC rises and value falls
- BWACC and value are unchanged
- CWACC falls and value rises due to the interest tax shieldCorrect
- DWACC falls and value falls
- WACC rises and value rises
Explanation
With corporate tax, interest is deductible, creating a tax shield. Cost of equity rises with gearing but not enough to offset the cheaper after-tax debt, so WACC falls and firm value rises. Without taxes, WACC would be unchanged.
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