Corporate Taxes

As already mentioned, MM agree that the value of the firm will increase and cost of capital will decline with leverage, if corporate taxes are introduced in the exercise. Since interest on debt is tax-deductible, the effective cost of borrowing is less than the contractual rate of interest. Debt, thus, provides a benefit to the firm because of the interest payments. Therefore, a levered firm would have greater market value than as unlevered firm. Specifically, MM state that value of the levered firm would exceed that of the unlevered firm by an amount equal to the levered firm’s debt multiplied by the tax rate. Symbolically,

Vi = Vu + Bt

where,     Vi = value of levered firm
Vu = value of unlevered firm
B = amount of debt
t = tax rate

Since the value of the levered firm is more than that of the unlevered firm, it is implied that the overall cost of capital of the former would be lower than that of the latter.

Equation 15.14, also implies that the market value of a levered firm (Vi) is equal to the market e of an unlevered firm (Vu) in the same risk class plus the discounted present value of the tax saving resulting from tax-deductibility of interest payments.

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