Final answer:
A quirk in the tax code that makes a levered firm more valuable than an unlevered firm is related to interest tax shields. Levered firms can deduct the interest they pay on their debt from taxable income, increasing their cash flows and value.
Step-by-step explanation:
The quirk in the tax code that makes a levered firm more valuable than an otherwise identical unlevered firm is related to interest tax shields. A levered firm can deduct the interest it pays on its debt from its taxable income, reducing the amount of taxes it needs to pay. This tax shield increases the cash flows available to the levered firm and can increase its value.
For example, let's say there are two firms, one levered and one unlevered, with the same earnings before interest and taxes (EBIT). The levered firm has debt and pays interest, while the unlevered firm has no debt. The levered firm can deduct the interest expense from its EBIT, resulting in a lower taxable income and therefore lower taxes paid. This lower tax payment increases the firm's net cash flow, making it more valuable.
Learn more about Tax code quirks