Estimating the Tax Benefits of Debt

n 1958, Nobel Laureates Franco Modigliani and Merton Miller published their famous irrelevance theorems.1 One implication from these theorems is that ers and the U.S. government. Panel A of Figure 1 shows that if the corporate tax rate is 33.3%, the government gets one-third of the pie for an all-equity firm, and stockholders get the remaining two-thirds. But if the firm chooses to finance with 50% debt and corporate income is taxed, a new wrinkle emerges (Panel B). Because the interest on debt is tax deductible, by financing with debt a firm reduces its tax liability, thereby reducing the portion of the pie given away to the government. As long as debtholders receive their portion of the pie, the stockholders get what’s left over (because they are the residual owners of the firm). Therefore, stockholders get to pocket the tax savings that are achieved by financing with debt. How much do these tax savings add to firm value? In their 1963 paper, Modigliani and Miller provided a formula to quantify the magnitude of tax savings under certain circumstances. If debt is riskless, then each year a firm will pay rD in interest payments, where r is the interest rate and D is the face amount of debt. One dollar of interest saves the firm from paying t($1) in taxes, where t is the corporate income tax rate, and $rD of interest reduces the firm’s tax liability by t($rD). Assuming that the firm issues perpetual debt (or that it always rolls the debt over as soon as it matures) and that the tax shields are no riskier than the debt that generates them, then from the well-known formula to value perpetuities (cash flow divided by the discount rate), the present value of the tax savings attributable to interest deductions is t(rD)/r. Noting that the r in the denominator