Question

8. M&M and Miller models After Modigliani and Miller's (MM) original no-tax theory, they went on to develop another theory that included corporate taxes. Subsequently, Miller developed another theory that included the effects of both corporate and personal taxes Complete the following sentence based on your understanding of the MM Model with corporate taxes: the benefit When personal taxes are included in the MM model, the taxes that stockholders pay on their bond and equity income created by the tax savings on corporate debt. Carrot Drug Company has no debt, and a value of $50.000 million. Ailing Pharmaceuticals Company is otherwise identical but has $20.000 million of debt in its capital structure, under the different models, what is the value of Ailing Pharmaceuticals Company if its corporate tax rate is 35%, the personal tax rate on equity is 8%, and the personal tax rate on debt is 28%? (Note: Do not round intermediate calculations.) Model MM without taxes MM with corporate taxes Miller with corporate and personal taxes Ailing Pharmaceuticals Company Value Consider the following information: Adding personal taxes to the model lowers, but does not eliminate, the benefit from corporate debt. In the United States, taxes on capital gains are lower than on ordinary income and can be deferred. The effective rate on stock income is normally less than that on bond income, and although the personal tax on debt will lower the gain from corporate debt, it is not usually enough to eliminate it. Therefore, there is still a gain from leverage using Miller's model, as well as the MM model with corporate tax. Is the preceding information correct? O No O Yes

Answer 1

When personal taxes are included in the MM model, the taxes that stockholders pay on their bond and equity income lowers (or decreases) the benefit created by the tax savings on corporate debt.

Value of Ailing Pharmaceuticals Company:

1). Under MM without taxes, its value will be same as that for an unlevered firm so its value is Vu = 50 million

2). Under MM with corporate taxes, value of levered firm VL = Vu + (debt*corporate tax rate)

= 50 + (35%*20) = 50 + 7 = 57 million

3). Under Miller with corporate tax (Tc), personal tax on equity (Ts) and personal tax on debt (Td):

Value of the firm = Vu + Debt[1-(1-Tc)(1-Ts)/(1-Td)]

= 50 + 20*[ 1 - (1-35%)*(1-8%)/(1-28%)] = 50 + (20*0.1694) = 50 + 3.3889 = 53.39 million

Yes, the preceding information is correct. Personal taxes lower but do not completely eliminate the effect of leverage.