According to Modigliani-Miles theorem with corporate taxes, how does leverage affect firm value?

• A. Leverage reduces firm value due to bankruptcy risk
• B. Leverage increases firm value by the tax shield Tc*D due to debt
• C. Leverage has no effect on firm value
• D. Leverage increases firm value only if equity financing is used

Answer: (B)

The main idea being tested is that debt creates a tax shield which increases the value of the firm when corporate taxes are present. Interest on debt is tax-deductible, so the firm reduces its taxable income by the interest expense. This lowers taxes paid, producing a tax shield equal to Tc times the debt level. If that shield is valued (as in a perpetual or consistently maintained debt scenario) its present value adds to the firm’s value. Under Modigliani-Miles with corporate taxes, the levered firm’s value is the unlevered value plus the value of the tax shield: V_L = V_U + Tc·D. So, increasing leverage raises firm value by the amount of the tax shield, Tc·D, assuming no bankruptcy or distress costs and other standard market assumptions.