In a world of Modigliani and Miller (1958), there are two firms, 1 and 2, where 1 is unlevered and 2 is levered: V1 = E and V2 = D2 + E2.
Both have the same asset generating X.
The firm can borrow at a rate of r. Assume that debt is riskless, X ≥ D2. Investors are taxed at a rate of tD for income from debt, and tE for income from equity. If investor’s tax rates tD and tE are the same, show that V1 = V2 using no arbitrage argument.