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Unformatted text preview: MM with Corporate Taxes 1 Previously we showed that when there are no taxes or other capital market im- perfections, the value of the firm was independent of the percent of debt and equity in the capital structure. How do taxes change our conclusions? Under the U.S. tax code, and the tax code in many other countries, interest payments on debt are tax deductable. As we will see, this implies that capital structure will no longer be irrelevant to the value of the firm. Proposition : Assume corporate income is taxed, but there are no other market im- perfections. Then the value of the firm is the value if the firm were all equity financed, plus the present value of the tax shield . This statement says that taking on debt can increase the value of the corporation, through the present value of the tax shield. It is illustrated in the following example. Example: Suppose there are two firms, identical in every way except for capital struc- ture. One firm is unlevered (all-equity). We will call it...
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