Microlesson · 5-min read

Modigliani-Miller (MM) Approach - With Tax

# Modigliani-Miller Approach - With Corporate Tax

When corporate taxes are introduced, interest on debt becomes tax-deductible, creating a tax shield that increases firm value with leverage.

## Cost of Equity in a Levered Firm (MM with Tax)

Keg = Keu + (Keu - Kd) * [Debt(1-t) / Equity]

### Notation

Symbol	Meaning
Keg	Cost of equity in a levered company
Keu	Cost of equity in an unlevered company
Kd	Cost of debt (pre-tax)
t	Corporate tax rate
Debt / Equity	Market value weights

## Key Implication

Cost of equity still rises with leverage to compensate for financial risk.
But because of the (1 - t) factor, the rise is less steep than in the no-tax version.
Therefore, firm value increases with leverage by the PV of the tax shield:

V_L = V_U + (D * t)

Worked example

### Example 1

Illustration: Keu = 15%, Kd = 10%, Debt = Rs. 40 lakh, Equity = Rs. 60 lakh, t = 30%.

Keg = 15% + (15% - 10%) [40 (1 - 0.30) / 60]

= 15% + 5% * (28/60)

= 15% + 2.33%

= 17.33%

Forgetting the (1 - t) multiplier on the Debt term
Using book values instead of market values for Debt/Equity weights
Concluding that firms should be 100% debt-financed — MM with tax ignores bankruptcy and agency costs

Reference:

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