Corporation Income Taxes and the Cost of Capital: A Revision

James W. Kolari () and Ignacio Velez-Pareja ()

No 7702, Proyecciones Financieras y Valoración from Master Consultores

Abstract: The value of debt tax shields in foundational corporate valuation models by Nobel Laureates Modigliani and Miller (MM) continues to be a controversial issue that is central to our understanding of corporate finance. This paper argues that a fundamental valuation problem exists in the MM tax models. To overcome this problem, we propose a revision to their now famous tax correction model that yields much smaller tax gains on debt usage. Rather than discounting debt interest payments using a riskless interest rate or unlevered equity rate, due to implausible valuation results implicit in this approach, the levered cost of equity is employed. Assuming no bankruptcy risk and no personal taxes, the proposed revised tax model yields an inverted U-shaped firm value function with an interior optimal capital structure. Analyses are extended to Miller´s personal tax extension of MM´s tax model. Also, implications to corporate capital structure decisions and previous literature are discussed.

Keywords: Value of Tax Shields; Capital Structure; Firm Valuation; Share Valuation (search for similar items in EconPapers)
JEL-codes: G12 G31 G32 (search for similar items in EconPapers)
Pages: 48
Date: 2010-11-30
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Persistent link: https://EconPapers.repec.org/RePEc:col:000463:007702

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