Financial Leverage is Influenced by Tax Deductibility

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Financial Leverage is Influenced by Tax Deductibility
Olawale Christopher Olamiju, Member
It is true that financial leverage could be used to magnify the rate of return on shareholders' equity as a result of the tax deductibility of interest payments.
The beauty of the extent to which financial leverage can be used in this perspective is better appreciated going by the various propositions of Modigiliani and Miller as well as the Trade Off theory.

Influence of Modigliani–Miller Theorem on Financial Leverage
Jaap de Jonge, Editor
Hi Olawe, interesting.
Wikipedia says the Modigliani–Miller theorem is the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.
Could you please explain a bit further what is the meaning of the Modigliani–Miller theorem and Trade off theory for financial leverage?

Tax Shield is a Determinant to Determine the Leverage
ling, Member
@Jaap de Jonge (Editor): Modigiliani and Miller theory is under friction conditions: this means that only in:
- perfect markets,
- the absence of taxes,
- no bankruptcy costs, and
- full information,
financing decisions (capital structure) are irrelevant to a firms’ market value.
In reality these conditions do not exist, so clearly in normal circumstances financing decisions (capital structure) ARE influencing the value of a firm!

Influence of Modigiliani and Miller on Financial Leverage
Olawale Christopher Olamiju, Member
@Jaap de Jonge (Editor) : the definition in Wikipedia is proposition 1 of the Modigiliani and Miller theorem, which is based on a simple utopian world of no taxes, bankruptcy costs etc.
Hence the conclusion that the value of a company as an entity cannot be enhanced by introduction of debt in its capital structure.
The implication is that:
(1) it would be a futile efforts if a finance manager uses debt with a view to shove up the value of his/her company
(2) that the value of an ungeared/unleveraged company is the same as the value of a geared / unleveraged company i.e. vg = vu = ve. Note vg = ve + vdt, (t = tax rate =0).
Proposition 2 looks at the implicit cost of debt (risk) on the shareholders' expected return which in common sense is expected to be higher because of exposure to more risk occasioned by additional of debt to capital structure. Therefore as more debt is introduced, the cost of equity increases... To be continued.


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