TAX CODE REVISION AND THE VALUE OF TAX-DEDUCTIBLE DEBT

William Lewis Randolph

Norfolk State University , Norfolk , VA

Abstract

This paper examines a tax policy change that would eliminate the interest expense as a tax-deductible item for businesses. We analyze this change using a tax revenue neutral setting in a Modigliani-Miller world. The analysis uses two scenarios to compare the change to the present U.S. Tax Code. Scenario one assumes a non-competitive environment with sticky prices. Scenario two assumes that companies or industries with low leverage would cut prices in- stead of realizing excess profits. The reduction in prices will redistribute the present value of the corporate tax shield from the stockholder to the consumer: Using the Modigliani-Miller methodology for valuation, the maximum value (equivalent to theoretical value in this case) of the tax shield is approximately $7 J 2 billion. The actual value is probably less than half the theoretical amount. Under either scenario, the weighted average cost of capital increases for levered firms

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