Final answer:
The value of a levered firm is higher than that of an unlevered firm due to the tax shields on interest payments, which lower the taxes paid and increase the firm's value.
Step-by-step explanation:
The value of a levered firm will be higher than the value of an identical unlevered firm because the levered firm's taxes will be lower, a principle known as the trade-off theory. This theory, stemming from Modigliani and Miller's propositions including corporate taxes, postulates that leveraging (i.e., borrowing) allows firms to benefit from tax shields on interest payments, thereby reducing taxable income and taxes paid. These tax savings can effectively increase the value of the firm. However, it is worth noting that increasing leverage also increases financial risk, which can affect the firm's cost of capital, and thereby, its value.