Lesson 5 of 6 · 14 min

Modigliani-Miller with taxes, and the cost of financial distress

Because interest is tax deductible, debt adds the value of its tax shield, lowers WACC and in theory makes 100% debt optimal, until the costs of financial distress, which MM's basic model ignores, are counted.

In short

  • Proposition I with taxes: VL=VU+tDV_L = V_U + tD; tDtD is the present value of the debt tax shield.
  • The higher the tax rate, the bigger the benefit of debt; a profitable firm can raise its value by borrowing.
  • Proposition II with taxes: re=r0+(r0−rd)(1−t)DEr_e = r_0 + (r_0 - r_d)(1 - t)\frac{D}{E}: the cost of equity still rises, but more slowly, so WACC falls as debt rises.
  • Taken literally (taxes, no distress costs), 100% debt is optimal, which contradicts reality.
  • Financial distress: direct costs (legal, administrative) and indirect costs (lost customers, suppliers, staff, opportunities, reputation, agency costs of debt).
  • Distress costs are lower when assets have a ready secondary market; the probability rises with debt, sales risk, operating leverage and low liquidity.

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Modigliani-Miller with taxes, and the cost of financial distress · Capital Structure