Modigliani
and Miller with Tax
Modigliani
and Miller with tax theory can be explained in terms of WACC falls, Value of
money, and cost of equity increased.
1. Value of Company
Modigliani and miller theory with tax
states that value of geared company is higher than un geared (all equity
Company) due to lower WACC, we know that WACC and value of company has inverse
relationship i.e. value of company increase with lower WACC.
Vg= Vu+ Dt
Dt= Value of tax on debt
Example
Market Value Company is 70 million, cost of
equity is 8%, Debt financing was 20 million used to reduced equity level, cost
of debt is 5%,then value of geared company may be calculated as follow; tax
rate is 30%
Vg = 70 million + [(20 x .3]
=70+6
=76 Million (Value of Company)
2. WACC Falls
Modigliani
and miller theory says that effect of cheaper debt is more powerful, therefore
WACC tends to decrease with more gearing.
WACC
g = WACC u [1- Dt/(D+E)]
Dt= Value of tax on debt
D+E = Total new value (Geared
Co)
Market Value Company is 70 million, cost of equity is
8%, Debt financing was 20 million used to reduced equity level, cost of debt is
5%,then value of geared company may be calculated as follow; tax rate is 30%
= 8% + 1 – [6/76]
=7.36%
3. Cost of Equity increase
Modigliani and miller theory with tax explains that Cost
of equity rises in geared company; cost of equity must not be confused with
WACC which tend to fall. This rise has been explained by the following formula
Keg= Keu + D/Eg (keu-Kd) (1-t)
= 8% + 20/56 ( 8% - 5% ) (.7)
=8.55%
