THE AMERICAN ECONOMIC REVIEW C. Some qualifications and Extensions of the Basic Proposition The methods and results developed so far can be extended in a num- ber of useful directions, of which we shall consider here only three: (1) allowing for a corporate profits tax under which interest payments are deductible; (2) recognizing the existence of a multiplicity of bonds and interest rates; and(3)acknowledging the presence of market imperfect tions which might interfere with the process of arbitrage The first two will be examined briefly in this section with some further attention given to the tax problem in Section II. Market imperfections will be dis- cussed in Part D of this section in the course of a comparison of our re sults with those of received doctrines in the field of finance Efects of the Present Method of Taring Corporations. The deduction of interest in computing taxable corporate profits will prevent the arbi trage process from making the value of all firms in a given class propor tional to the expected returns generated by their physical assets. I stead, it can be shown(by the same type of proof used for the original version of Proposition I) that the market values of firms in each class must be proportional in equilibrium to their expected return net of taxes(that is, to the sum of the interest paid and expected net stock- holder income). This means we must replace each X, in the original ver sions of Propositions I and II with a new variable X, representing the total income net of taxes generated by the firm X=(X-rD)(1-T)+TD≡亓+rD where i' represents the expected net income accruing to the common stockholders and r stands for the average rate of corporate income tax. After making these substitutions, the propositions, when adjusted for es continue to have the form as their originals. That is, Pro sition i becomes (11) r any frm in and Proposition II becomes (12) r)Di/s where pris the capitalization rate for income net of taxes in class Although the form of the propositions is unaffected, certain interpre- tions must be changed. In particular, the after-tax capitalization rate Is For simplicity, we shall ignore throughout the tiny element of progression in our present rporate tar and treat r as a constant independent of (XI-TDd