Explain MM proposition II under conditions of corporate taxes and risk-free debt. How does the analysis...
Explain MM proposition II under conditions of corporate taxes and risk-free debt. How does the analysis change when debt can be risky?
Homework Answers
According to MM proposition II, taking leverage helps increase the value of the company. Since debt has a tax advantage, it can increase the value of the company. Since the interest on debt is a tax deductible, this helps increase the overall profits generated.
According to MM proposition II, the value of the levered company is as shown below:
VL = VU + Tc*D where
VL is the value of the levered company
VU is the value of the company with no leverage or 100% Equity
Tc = Corporate tax rate and
D = Level of debt,
Yes, the analysis changes when the debt is risky. The company can only take a certain level of debt, call the optimal level of debt that can be risk free. If the company takes on too much debt , the cost of debt can become risky as it increases the bankruptcy and financial distress costs.
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Explain MM proposition II under conditions of corporate taxes
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