The tax deductibility of interest is considered to be the main lever for creating the value of debt according to Modigliani and Miller because it is the only element that makes it possible to break the principle of “neutrality” of the financial structure.

Here is the detailed explanation of this mechanism according to the documents:

1. The basic principle: neutrality in the absence of taxes

The work of Modigliani and Miller has shown that in the absence of taxation (and bankruptcy costs), the value of the company is not altered by its financing.

• The illusion of lower cost: One might think that replacing equity (which is expensive, e.g. 10%) with debt (cheaper, e.g. 6%) reduces the average cost of capital (WACC). This is false in the absence of taxation.
• Risk compensation: If the company goes into debt, the financial risk for shareholders increases. As a result, they require higher profitability (via increased Beta in Hamada’s formula). This increase in the cost of equity exactly cancels out the savings made by the lower interest rate on the debt.

2. The impact of taxation: the only real gain

The introduction of corporate income tax changes this equation only because the remuneration of creditors (financial expenses) is treated differently from that of shareholders:

• The tax shield: Financial expenses are deductible from taxable income. The State therefore “subsidizes” part of the cost of the debt. The real cost to the company is not the interest rate (${\mathrm{I}}_{\mathrm{D}}$), but the after-tax rate:${\mathrm{I}}_{\mathrm{D}}\times (1–\mathrm{T})$.
• Value creation: It is this tax saving that lowers the WACC when the company goes into debt. As a decrease in the WACC mechanically increases the value of the company (present value of future flows), the debt then creates a value linked to the deductibility of financial expenses.

Conclusion

We should not believe that debt creates value because the interest rate is lower than the return demanded by shareholders. The only gain is tax. If financial expenses were not deductible, the debt would not bring any benefit in terms of value.

This tax advantage of debt was a decisive incentive in the leveraged acquisitions (LBOs) of the 80s in the United States, because interest rates were well above 10% and the marginal tax rate on profits was 50%. The state paid half of the cost of the debt.