Question

M&M described the relationship between capital structure and firm value, in a world with corporate taxes, as follows: VL = VU + τD (where τ is the corporate tax rate and D is the firm’s amount of debt). Note that they also said VL = VU when there were NO corporate taxes. Explain what you think this formula says about the relationship between firm debt usage and firm value. Then explain one aspect of the real world that discourages firms from maxing out their debt use. Note there are many aspects of the real world that do this – the question is just asking you for one.

Answer 1

MM Theory says that the value of a levered firm would be equal to the value of the unlevered firm when there are no taxes but when there are corporate taxes the value of a levered firm is equal to the value of an unlevered firm plus the tax rate multiplied by the debt.

Value Levered firm = Value Unlevered firm + Tax rate * debt

The relationship here shows that the value of a levered firm will increase because of the use of debt, it is because the interest payment on debt is tax deductible and the WACC of the firm reduces so the value should also increase.

The reason why many firms are discouraged to use too much debt in their capital structure because with rise in debt the financial distress cost increases and the distress cost might outweigh the benefit associated with the tax break on interest payment.