Question

4. Discuss MM’s later models (1963) in which they relaxed the no-tax assumption and added corporate taxes. Discuss Proposition I and II. Miller added personal taxes to the model in his 1976 Presidential Address to the American Finance Association. What happens to Miller’s model, in general, if there are no corporate or personal taxes? What happens when only corporate taxes exist?

Answer 1

The Modigliani and Miller propositions says the following:

Suppose that there are no taxes or costs of financial distress Then,

Proposition I: The value of the firm is independent of the percentage of debt or equity in its capital structure.

Proposition II: The cost of equity capital is increasing in the percentage of debt in the capital structure.

rE = r0 + D E (r0 − rD)

where, r0 is the cost of capital if the firm were financed entirely with equity.

If there are no corporate taxes then,

• capital structure does not influence the valuation of the firm.
• leveraging the company does not increase the market value of the company
• debt holders and equity shareholders in the company have same priority

when the corporate tax exists,

• Change in debt component can affect the value of the firm
• Change in debt equity ratio will affect the WACC (weighted average cost of capital)
• higher the debt, lower the WACC