14.7Taxes and Municipal Bonds

The largest shareholders in a corporation are likely to be either tax-exempt investors

or individuals who pay the maximum personal tax rate. Recall that tax-exempt investors

experience an increase in their cash flows when the firms whose shares they own

increase their leverage. If these investors find the additional risk associated with the

leverage increase undesirable, they can undo it by selling some of their stock and buy-

ing the corporation’s bonds. However, the analysis in Section 14.5 suggests that share-

holders in a high tax bracket have an offsetting personal tax cost associated with an

increase in the firm’s leverage. As a result, conflicts between the interests of taxable

and tax-exempt shareholders are likely.

In general, the taxable and tax-exempt shareholders will not agree about the correct

capital structure policy for a corporation. However, our analysis may have exaggerated

Grinblatt1053Titman: Financial	IV. Capital Structure	14. How Taxes Affect	© The McGraw1053Hill
Markets and Corporate		Financing Choices	Companies, 2002
Strategy, Second Edition

520Part IVCapital Structure

EXHIBIT14.6Historical Yields on AAATaxable and Tax-Exempt Bonds

	Municipal
	Bond	Corporate Bond
Year	Yield (%)	Yield (%)	T	(1 T) (Corp. Bond Yield) (%)
			c	c

1960	4.1%	4.6%	0.48	2.4%
1970	5.2	7.6	0.48	4.0
1980	9.4	13.2	0.46	7.1
1990	6.6	9.1	0.34	6.0
1995	5.4	6.8	0.35	4.4
2001	5.7	6.8	0.35	4.4

the personal tax costs associated with debt for shareholders in the maximum tax brack-

ets because it ignores the ability of taxable investors to lower their personal tax burdens

by holding tax-exempt municipal bonds in lieu of corporate bonds. Historically, yields on

tax-exempt municipal bonds, while less than corporate bond yields, have generally been

substantially greater than the after-tax yields on corporate bonds for investors in high tax

brackets (see Exhibit 14.6). This suggests that corporations can probably increase the after-

tax cash flow to their high-tax-bracket shareholders, as well as their low tax bracket share-

holders, by increasing leverage, with shareholders undoing or, offsetting, this increase,

if they so desire, by selling shares and increasing their tax-exempt bond holdings.

To illustrate this point, reconsider Example 14.3, where the investor initially holds 10

percent of the firm’s equity and in the absence of corporate taxes realizes a cash flow of

˜

.1[Xr$10,000]

D

With corporate taxes, the cash flow to the investor will be

.1[˜r$10,000](1T)

X

Dc

Assume once again that the firm wishes to increase its leverage, so it repurchases

$50,000 of its outstanding shares and issues $50,000 in corporate bonds. In the no-tax

example, the investor was able to undo the effect of this increase in leverage on his or

her personal portfolio by selling $5,000 of the firm’s stock and buying $5,000 of the

new corporate bonds. However, given personal taxes, the individual may be better off

using the proceeds from the sale of $5,000 in stock to buy municipal bonds with returns

of rrather than to buy the corporate bonds. If the firm increases its leverage and the

m

investor undoes the effect of this action by buying tax-free municipal bonds, he or she

will receive an after-tax cash flow of

.1[˜$60,000](1T)(1T) r$5,000

Xr

DcEm

Rearranging terms in the above expression yields the following expression for the after-

tax cash flows of a taxable investor holding stock plus municipal bonds:

.1˜)(1T).1r($10,000)(1T)(1T)

X(1T

cEDcE

[rr(1 T)(1 T)] ($5,000)

mDcE

where the bracketed term [rr(1 T)(1 T)] $5,000 is the gain in after-tax

mDcE

cash flows from this transaction.

Exhibit 14.6 shows that this bracketed term has been positive for at least the last

40 years. Hence, even investors with the greatest personal tax preference for equity

Grinblatt1055Titman: Financial	IV. Capital Structure	14. How Taxes Affect	© The McGraw1055Hill
Markets and Corporate		Financing Choices	Companies, 2002
Strategy, Second Edition

Chapter 14

How Taxes Affect Financing Choices

521

(typically, those in the highest income tax bracket) could have higher after-tax cash

flows if the firms in which they held equity had higher debt-to-equity ratios.