Modigliani/Miller (1963) tax correction paper

Addresses first assumption leading to irrelevance proposition.

Three claimants on the value of the firm:

1. shareholders
2. bondholders (if there are any)
3. government (tax on profits)

Consider an all equity firm:

Now consider a firm which swaps debt for equity:

What happens when we do debt-for-equity swap?

Increased debt increases interest expense

1. increase tax deduction
2. increase present value of interest tax shield
3. decrease present value of tax liability
4. increase present value of private claims on the firm

What determines the amount of debt you take on?

Are there any costs associated with taking on debt?