Rethinking MM2: Tax shields and equity valuation

Abstract

The Modigliani-Miller Proposition II (MM2) posits a linear relationship between a firm's leverage and the cost of equity in frictionless markets. We extend MM2 by analyzing equity cost and valuation when tax shields are influenced by endogenous factors. We show that, without considering real-world complexities or frictions such as bankruptcy costs and dynamic market conditions, equity valuation can become indeterminate. By refining MM2's theoretical framework, our result underscores the role of contextual factors in bridging the gap between theory and practice.