gnrocks, no, that’s not why there’s no (1-t) in Level II. You’re thinking about debt beta, which is usually only for high yield bonds where interest payments are less certain, and defaults may not cover all losses. You could take your methodology a step further even and strip out debt beta, equity beta, and operational beta due to the ratio of fixed costs per variable costs.
We are valuing the operations of small companies now, not mature companies as we were in Level I. With these smaller companies, we assume a continuous rebalance of financial leverage (D/E), not a constant absolute debt float. Since this ratio is always a proportionate value to the unleveraged company, the tax shield itself become a perpetuity with an expected return equal to the cost of capital in MM1 w/o taxes.
Look at the curriculum footnotes. Check out the Robert Hamada’s equation from 1972 and the critique by Harris and Pringle in 1985. It’s company size/prospects here that dictates why we’ve left out (1-t). It’s similar to how real estate is valued with capitalization, actually.