Question

hen valuing stocks, we can use two methods: cash flow to equity and cash flow to the firm. Using met hod one, when leverage increases, cash flow declines and discount rate increases, thus leading to a lower PV. Instead, Modigliani-Miller tells us that, in a world with taxes, leverage tends to increase value. Explain this paradox

Answer 1

Increase in leverage means an increase in debt which increases the interest expenses. Increase in interest expense decreases the cash flow to equity whereas tax shield due to interest and increase in debt will increase the cash flow to equity.

Since the amount of debt is much higher than the interest expense, therefore the increase in leverage will lead to an increase in cash flow to equity.

As leverage increases the cost of equity also increases but the present value of cash flow to equity will be higher due to higher value of debt.

Thus the value of equity will increase due to leverage and hence the value of firm will increase due to leverage.