Why does the MM theory with corporate taxes lead to 100% debt?

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Why does the MM theory with corporate taxes lead to 100% debt?

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Why does the MM theory with corporate taxes lead to 100% debt?

Explanation & AnswerSolution by a verified expert

Explanation

The deductibility of the interest payments shields the firm's pre-tax income which leads to maximise the firm's value when the company has to pay interest to the debt holders. So the company uses 100% debt to pay more of its income to debt holders.
As if a company uses 100% debt then more income of the firm will go to their debt holders as interest payment and then the company will have to pay less taxes to the government. And paying more interest to the debt holders will maximise the firm's value.

Verified Answer

The MM theory with corporate taxes assumes that if interest is paid to debt holders, then this would reduce the tax payment to the government as the interest payment is tax deductible. Thus, it will lead to use of 100% debt.

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