Debt financing has one important advantage that the early Modigliani and Miller (MM) propositions ignored: the interest on business debt is tax deductible. This benefit means that the amount of taxes that a business is required to pay will be reduced by a phenomenon called an interest tax shield, which is a function of the amount of debt in the firm's capital structure and its tax rate. In contrast, the dividends that a corporation pays on its common and
preferred shares are not tax deductible.

Consider the case of Green Llama Foodstuffs, Inc.:

At the beginning of the year, Blue Chipmunk Foodstuffs, Inc. had an unlevered value of $8,500,000. It pays federal and state taxes at the marginal rate of 40%, and currently has $2,500,000 in debt capital in its capital structure.

According to MM Proposition I with taxes, Green Llama Foodstuffs is allowed to recognize a tax shield of , and the levered value of the firm is:

a. $7,100,000
b. $12,500,000
c. $9,900,000
d. $4,500,000