MM Proposition I with Corporate Taxes (1963)
Firms pay taxes on profits after deducting interest payments. This creates an incentive to use debt.
| With Leverage | Without Leverage | |
|---|---|---|
| EBIT | 1850 | 1850 |
| Interest expense | -350 | 0 |
| Income before tax | 1500 | 1850 |
| Taxes (35\%) | -525 | -648 |
| Net income | 975 | 1202 |
| With Leverage | Without Leverage | |
|---|---|---|
| Interest paid to debt holders | 350 | 0 |
| Income available to equity holders | 975 | 1202 |
| Total available to all investors | 1325 | 1202 |
Additional value from debt tax shield:
\[ 35\%\times 350\text{ million}=123\text{ million}. \]
\[ \text{Interest Tax Shield}=\text{Corporate Tax Rate}\times \text{Interest Payments}. \]
\[ \begin{aligned} \text{Cash flows to investors (with leverage)} &=\text{Cash flows to investors (without leverage)}\\ &\quad+\text{Interest Tax Shield}. \end{aligned} \]
MM Proposition I with corporate taxes:
\[ V^L=V^U+PV(\text{Interest Tax Shield}). \]
Under perpetuity with risk-free debt:
\[ PV(\text{Interest Tax Shield}) =\frac{t_c\cdot \text{Interest}}{r_f} =\frac{t_c(r_fD)}{r_f} =t_cD, \]
so
\[ V_L=V_U+t_cD. \]
In the MM world with only corporate taxes, the “optimal” structure is 100\% debt financing.