Question

When valuing stocks, we can use two methods: cash flow to equity and cash flow to the firm. Using method 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. (40 Marks)

Answer 1

The presence of taxes allows leverage (debt) to increase firm value owing to the benefits of the interest tax shield accruing to the firm. Any leverage has an associated interest expense which is tax deductible in nature. This tax deductibility of interest expense functions to create a value increasing interest expense tax shield for the firm. This tax shield in turns increases firm value. This might imply that a firm's value can be increased considerably by taking on more debt (increasing leverage), thereby increasing the interest expense tax shield and firm value. However, this is true only up to a certain point. Beyond this point, any increase in leverage decreases the cash flow to equity along with increasing the firm's cost of debt (discount rate). These two developments work to decrease the firm's value. Hence, even though both facts mentioned above are true, the actual net increase (or decrease) in the firm's value depends on the relative magnitude of the value increasing interest expense tax shield and the value depressing higher discount rate and lower cash flow to equity. If the former is higher, the firm value will increase on a net basis and vice versa.