Tax shields “The trouble with MM’s argument is that it ignores the fact that individuals cannot deduct interest for personal income tax.” Show why this is not an objection if personal tax rates on interest and equity income are the same.
To discuss: The reason why it is not an objection if personal tax rates on equity and interest are same.
Explanation of Solution
Given situation:
The argument with MM theory is that it says it ignores the fact that a person cannot deduct the interest for personal income tax.
Reason:
For example, Firm A has a is a levered firm with expected cash flow X and interest on debt as
So, the cash flow to shareholders are as follows:
The value of shareholders position be as follows:
Here, r is the opportunity cost for all equity financed firm. Secondly, if the stockholder borrows D at the rate of same
The position of value of stockholder be:
Thus, the difference in the wealth of the shareholder for investment in same asset is as follows
The above is the prediction of MM theory.
Then if a person cannot deduct the interest for personal tax purpose then
Thus, the shareholders value position in a levered firm is greater when no personal interest deduction is allowed.
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Chapter 18 Solutions
Principles of Corporate Finance
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