Modigiliani Miller Propositions with Taxes

CFA Level II Corporate Finance
#1

I’m confused about MM Propositions 1 & 2 (with taxes).

Schweser writes:

  • The optimal proportion of debt and equity financing will minimize the firm’s WACC. This is also the capital structure that will maximize the value of the firm."
  • MM Proposition I (with taxes) - value is maximized at 100% debt; the tax shield provided by debt causes the WACC to decline as leverage increases.
  • MM Proposition II (with taxes) - WACC is minimized at 100% debt; the tax shield provided by debt causes the WACC to decline as leverage increases.

Maybe I’m misunderstanding something, but to me these appear to be the same thing. If value is maximized at 100% debt in prop I, then that means WACC is minimized at 100% debt. How is this different than MM Prop II (with taxes)?

#2

My understanding is that PropI is concerned with Firm value, while PropII is concerned with Cost of Equity.

#3

Proposition I, with taxes: Under a set of (very restrictive) assumptions, with corporate income tax, the value of the firm is maximized when the capital structure is 100% debt.

Proposition II, with taxes: Under a set of (very restrictive) assumptions, with corporate income tax, the firm’s WACC is minimized when the capital structure is 100% debt. Further, the cost of equity increases linearly with the firm’s debt-to-equity ratio.

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