WACC = (D/A)Rd(1-t) + (E/A)Re
Weighted average cost of capital = %of debt in capital structure times rate of debt reduced by tax benefit + %of equity times rate of equity.
We want to minimize WACC, so that NPV increases. That’s fine.
MM’s proposition with taxes says WACC is minimized by employing 100% debt (because Rd < Re). In the above equation if E=0, your cost of capital is only the first part, (D/A)Rd(1-t), so clearly you will have a lower WACC.
But, even *without* taxes, wouldn’t your WACC be lower too?
ok,ok,ok…I think I just answered myself (don’t you love how asking questions is good for you?). Answer is that it is true that WACC will be lower than if you use any equity, but it is *not* minimized. Only if there are taxes it becomes minimum.