MM Proposition I with Corporate and Personal Taxes (1977)
Not only corporate taxes (\(T_c\)), but also personal taxes must be considered.
| Operating Income | \(1\) | |
|---|---|---|
| Paid out as INTEREST | Paid out as Equity Income | |
| Corporate Tax | None | \(T_c\) |
| Income after corporate Tax | \(1\) | \(1-T_c\) |
| Personal Tax | \(T_{pD}\) | \(T_{pE}(1-T_c)\) |
| Income after all taxes | \(1-T_{pD}\) | \(1-T_c-T_{pE}(1-T_c)\) |
| \(=(1-T_{pE})(1-T_c)\) | ||
| Beneficiary | To Bondholder | To stockholder |
If operating income is paid as interest:
- firm pays no corporate tax (interest deductible),
- bondholder pays personal tax,
- after-tax payoff to bondholder: \(1-T_{pD}\).
If operating income is paid as equity:
- firm pays corporate tax \(T_c\),
- equity investor pays personal tax,
- after-tax payoff to stockholder:
\[ 1-T_c-T_{pE}(1-T_c)=(1-T_{pE})(1-T_c). \]
Relative advantage of debt over equity:
\[ \text{Advantage}= \frac{1-T_{pD}}{(1-T_{pE})(1-T_c)}. \]
- Ratio \(>1\): debt is better.
- Ratio \(<1\): equity is better.
Corporate tax advantage of debt exists only if:
\[ 1\cdot(1-T_{pD})\ge (1-T_c)(1-T_{pE}). \]
Special case 1: ratio \(=1\), i.e.
\[ (1-T_{pD})=(1-T_{pE})(1-T_c). \]
Then tax advantage vanishes, debt becomes tax-neutral versus equity, and MM'58 remains valid.
Special case 2: if \(T_{pE}=T_{pD}\), personal taxes do not distort the corporate tax benefit (classical case used in WACC practice). In this case,
\[ \text{Ratio}=\frac{1}{1-T_c}. \]
General valuation form used in the slide:
\[ V_L=V_U+ \left[ 1-\frac{(1-T_c)(1-T_s)}{1-T_d} \right]D. \]