ECONOMICS 448,
Review 4
16.12 The general expression for the value of a leveraged firm in a world in
which Ts=0 is
V
L
= V
U
+[1(1T
C
)(1T
S
)/(1T
B
)]BC(B)
where:
V
U
= Value of an unlevered firm
T
C
= Efficient corporate tax rate for the firm
T
B
= Personal tax rate of the marginal bondholder
B
= Debt level of the firm
C(B) = Present value of the cost of financial distress for the firm as a
function of its debt level. [Note: C(B) encompasses all nontaxrelated
effects of leverage on the firm’s value]
Assume all investors are riskneutral.
a. In their notax model, what do Modigliani and Miller assume about T
C
, T
B
and
C(B)? What do the assumption imply about a firm’s optimal debtequity ratio?
b. In their model that includes taxes, what do Modigliani and Miller assume
about T
C
, T
B
and C(B)? What do these assumptions imply about a firm’s
optimal debtequity ratio?
c. Assume that IBM is certain to be able to use its interest deductions to reduce
its corporate tax bill. What would the change in the value of IBM be if the
company issued $1 billion in debt and used the proceeds to repurchase
equity? Assume that the personal tax rate on bond income is 20 percent, the
corporate tax rate is 34 percent, and the cost of financial distress is zero.
d. Assume that USX is virtually certain not to be able to use interest
reductions. What would the change in the value of the company
be from adding $1 of perpetual debt rather than $1of equity?
Assume that the personal tax rate on bond income is 20 percent,
the corporate tax rate is 35 percent, and the cost of financial
distress is zero.
e. For companies that may or may not be able to use the interest
deduction, what would the change in the value of the company be
from adding $1 of perpetual debt rather than $1 of equity? Assume
that the personal tax rate on bond income is 20 percent, the
corporate tax rate is 35 percent, and the costs of financial distress
are zero. Also assume the probability of using the incremental
deduction is 65 percent.
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 Spring '06
 Bejan
 Finance, Economics, corporate tax rate

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