Final answer:
The Modigliani-Miller theory states that a levered firm is more valuable than an unlevered firm due to the tax deductibility of interest payments, which creates a tax shield and reduces the company's overall tax liability.
Step-by-step explanation:
According to the Modigliani-Miller theory, the quirk in the tax code that makes a levered firm more valuable than an otherwise identical unlevered firm is the tax deductibility of interest payments. Firms that use debt financing can deduct interest expenses from their taxable income, thereby reducing their overall tax liability. This creates a tax shield because the tax savings from the interest deductions effectively reduce the cost of debt.
When a firm leverages its financing through borrowing, the interest payments on the debt are a tax-deductible expense. This means that by having debt in their capital structure, firms can reduce their taxable income and therefore pay less in taxes. This tax advantage of debt financing increases the value of a levered firm compared to an unlevered one, which has no debt and therefore no interest tax shield.
In essence, while Modigliani and Miller initially suggested that in a world without taxes, the value of a firm is not affected by how it is financed, the presence of taxes changes the scenario. The tax code, therefore, creates an environment where debt financing can be more attractive due to the tax benefits associated with it, giving a levered firm a higher value than an unlevered one.