hard · Principles of Finance valuation

Holding the unlevered cost of capital, target leverage, and pre-tax cost of debt all constant, which statement most accurately describes how the Miles–Ezzell levered value compares to the Modigliani–Miller (fixed-dollar-debt) levered value, and why?

1. Miles–Ezzell yields a lower value because only the first year's interest tax shield is discounted at the cost of debt while all later shields are discounted at the riskier unlevered cost of capital.
2. Miles–Ezzell yields a higher value because rebalancing makes every period's tax shield certain, so all shields are discounted at the risk-free rate rather than the unlevered cost of capital.
3. Miles–Ezzell yields an identical value because both methods capitalize the same steady-state tax shield, differing only in the cosmetic timing convention of when interest is paid.
4. Miles–Ezzell yields a lower value because the tax shield grows with firm value and so is discounted at the unlevered cost of capital from year two onward, capturing its dependence on future uncertain cash flows.

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