Chapter 18 How Much Should a Corporation Borrow? 463
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Table 18.4B shows the new balance sheets. The book version simply has $10,000 million
more long-term debt and $10,000 million less equity. But we know that Johnson & Johnson’s
assets must be worth more because its tax bill has been reduced by 35% of the interest on the
new debt. In other words, Johnson & Johnson has an increase in PV(interest tax shield), which
is worth TcD = .35 × $10,000 million = $3,500 million. If the MM theory holds except for
taxes, firm value must increase by $3,500 million to $335,624 million. Johnson & Johnson’s
equity ends up worth $293,100 million.
Now you have repurchased $10 billion worth of shares, but Johnson & Johnson’s equity
value has dropped by only $6.5 billion. Therefore Johnson & Johnson’s stockholders must be
$3.5 billion ahead. Not a bad day’s work.^4
MM and Taxes
We have just developed a version of MM’s proposition 1 as corrected by them to reflect cor-
porate income taxes.^5 The new proposition is
Value of firm = value if all-equity-financed + PV(tax shield)❱ TABLE 18.4A Simplified
balance sheets for Johnson
& Johnson, September 2014
(figures in millions).
Notes:- Market value is equal to book value for
net working capital, long-term debt, and
other long-term liabilities. Market value of
equity = number of shares times closing price
for September 2014. The difference between
the market and book values of long-term
assets is equal to the difference between the
market and book values of equity. - PV interest tax shield assumes fixed, per-
petual debt, with a 35% tax rate.
Book Values
Net working capital $ 36,991 $ 13,152 Long-term debt
Long-term assets 72,124 19,372 Other long-term liabilities
76,591 Equity
Total net assets $109,115 $109,115 Total value
Market Values
Net working capital $ 36,991 $ 13,152 Long-term debt
PV interest tax shield 4,603 19,372 Other long-term liabilities
Long-term assets 290,530 299,600 Equity
Total net assets $332,124 $332,124 Total value❱ TABLE 18.4B Balance
sheets for Johnson & Johnson
with additional $10 billion of
long-term debt substituted for
stockholders’ equity (figures in
millions).Book Values
Net working capital $ 36,991 $ 23,152 Long-term debt
Long-term assets 72,124 19,372 Other long-term liabilities
66,591 Equity
Total net assets $109,115 $109,115 Total value
Market Values
Net working capital $ 36,991 $ 23,152 Long-term debt
PV interest tax shield 8,103 19,372 Other long-term liabilities
Long-term assets 290,530 293,100 Equity
Total net assets $335,624 $335,624 Total value(^4) Notice that as long as the bonds are sold at a fair price, all the benefits from the tax shield must go to the shareholders.
(^5) Interest tax shields are recognized in MM’s original article, F. Modigliani and M. H. Miller, “The Cost of Capital, Corporation
Finance and the Theory of Investment,” American Economic Review 48 (June 1958), pp. 261–296. The valuation procedure used in
Table 18.4B is presented in their 1963 article “Corporate Income Taxes and the Cost of Capital: A Correction,” American Economic
Review 53 (June 1963), pp. 433–443.