What does MM Proposition I with taxes state?

• A. Leverage always leaves firm value unchanged
• B. In the presence of taxes, leverage can affect firm value through the tax shield on debt
• C. Taxes eliminate any benefit from debt
• D. Leverage reduces firm value due to agency costs

Answer: (B)

Debt creates a tax shield because interest payments are tax-deductible, which lowers the firm’s taxable income and its taxes. That tax savings boost after-tax cash flows makes the levered firm more valuable than the same firm with no debt. In a simple, perpetual-debt setup, the value of the levered firm equals the value of the unlevered firm plus the present value of the tax shield from debt (often written as V_L = V_U + T_c × D). So, when taxes are present, leverage can raise firm value through this tax shield.

Keep in mind that other factors like bankruptcy costs or agency problems can offset the shield, but the core idea is that the tax-deductibility of interest makes debt worth more.