Capital Structure Theories^271value of a levered firm should tend to exceed that of the unlevered firm for this very
reason. This point is elaborated further in the following section.Relevance of Capital Structure:
The MM-Hypothesis under corporate TaxesM-Mís hypothesis that the value of the firm is independent of its debt policy is based
on the critical assumption that corporate income taxes do not exist. In reality, corporate
income taxes exist, and interest paid to debt holders is treated as a deductible expense.
Dividends paid to shareholders; on the other hand, are not tax-deductible. Thus, unlike
dividends, the return to debt-holders is not subject to the taxation at the corporate level.
This makes debt financing advantageous. In their 1963 article, M-M show that the
value of the firm will increase with debt due to the deductibility of interest charges for
tax computation, and the value of the levered firm will be higher than of the unlevered
firm. Consider an example.
Illusration 6: Suppose two firms L and U are identical in all respects except the use
of debtófirm U is an all-equity financed firm with Rs 10,000 equity capital while firm
L employs Rs 5,000 equity and Rs 5,000 debt at a 14 per cent rate of interest. Both
firms have an expected earning before interest and taxes of Rs 2,500, pay corporate
tax at 50 per cent and distribute 100 per cent earnings as dividends to shareholders.
The; after-tax earnings accruing to investors is shown in Table given below.
Note in Table that the liability of firm L is Rs 350 less than that of firm U. The total
income of investors ofí firm L is more by that amount. This amount is the interest tax
shield provided by the debt of firm L: 0.5 ◊ 0.14 ◊ 5,000 = 0.5 ◊ 700 = Rs 350. Thus
Interest tax shield = Tax rate ◊ Interest
INTS = T ◊ INT = T ◊ (kdD) ...(11)
where k, is the cost of debt and D is the amount of debt.
Table: Income of investors of levered and Unlevered firmís under corporate income tax
Income Firm U Firm L- EBIT, X 2,500 2,500
- Interest, INT = kdD 0 700
- Profit before tax, (X-kd D) 2,500 1,800
- Tax, T= 0.5, T(
X-kd, D) 1,250 900- Profit after tax, (
X- k, D) - T (
X- kdD) = (
X-kdD) (I - T) 1,250 900- Dividends to shareholders, (
X
- kd D) (I - T) 1,250 900
- Interest to debt holders, kd D 0 700
- Total income to investors, (
Xkd D) (I - T) + kdD
=X(1-T) + TkdD 1,250 1,600- Interest tax shield. TkdD 0 350