14.11Summary and Conclusions

This chapter analyzed how taxes affect the capital struc-tures of firms. In the absence of taxes and other market im-perfections, the value of a firm is independent of how it isfinanced. However, the interest tax deduction makes debtfinancing less expensive than equity financing, which im-plies that in the absence of personal taxes and other marketfrictions, firms should use sufficient debt to eliminate theirentire corporate tax liabilities.

Personal taxes somewhat offset the tax advantage ofdebt financing. Because equity returns (often taxed as capi-tal gains) are taxed at a more favorable personal rate thandebt, the pretax (zero-beta) expected rate of return on equitymay be lower than the pretax (zero-beta) expected rate ofreturn on debt. When considering personal as well as corpo-rate taxes, it is possible that the after-tax costs of zero-betadebt and equity are equal. However, current tax rates alongwith the observed gap between the rates on taxable corpo-rate bonds and tax-exempt municipal bonds suggest that, inreality, there is still a tax advantage to debt financing.

Although the analysis up to this point presents a fairlycomplete discussion of the corporate tax advantages of

debt financing, the discussion of personal taxes remains in-complete. Chapter 15, which completes our analysis oftaxes, analyzes how personal taxes affect a firm’s dividendpolicy. The effect of taxes on dividend policy can have animportant effect on its capital structure because earningsthat are not distributed to shareholders are retained withinthe firm and add to its equity base. Indeed, most new equityon corporate balance sheets comes from retained earningsrather than new equity issues. Hence, no discussion of theeffect of taxes on capital structure is complete without con-sidering the effect of taxes on dividend policy.

Of course, taxes are only one aspect of a corporation’scapital structure choice. Corporate executives often ex-press concerns about the ability of their firms to meet debtobligations and about how debt financing affects theirfirms’access to investment capital in the future. More re-cently, executives have started to consider the beneficialrole that debt has on management incentives, and theinformation conveyed to stockholders by their financingdecisions. These and other topics are discussed in futurechapters.

Key Concepts

Result	14.1:	(The Modigliani-Miller Theorem.)	transaction costs; and (3) no arbitrage
		Assume: (1) a firm’s total cash flows to	opportunities exist in the economy. Then,
		its debt and equity holders are not	if a firm’s existing debt holders have a
		affected by how it is financed; (2) there	senior claim in the event of bankruptcy,
		are no transaction costs; and (3) no	both the firm’s stock price per share and
		arbitrage opportunities exist in the	the value of its existing senior debt claims
		economy. Then the total market value of	are unaffected by changes in the firm’s
		the firm, which is the same as the sum of	capital structure.
		the market values of the items on the	Result 14.3:If a firm’s existing debt holders do not have
		right-hand side of the balance sheet (that	a senior claim in the event of bankruptcy,
		is, its debt and equity), is not affected by	a new debt issue can decrease the value
		how it is financed.	of existing debt. Under the assumptions
Result	14.2:	Assume: (1) a firm’s total cash flows to	listed in Result 14.1, however, the loss of
		its debt and equity holders are unaffected	the old debt holders would be offset by a
		by how it is financed; (2) there are no	gain to the equity holders, leaving the

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526Part IVCapital Structure

	total value of the firm unaltered by this	tax rate is T, then the value of a levered
		c
	type of capital structure change.	firm exceeds the value of an otherwise
Result 14.4:	Assume that the pretax cash flows of the	equivalent unlevered firm by TD;that is
		g
	firm are unaffected by a change in a
		VV TD,
	firm’s capital structure, and that there are	LUg
	no transaction costs or opportunities for	where
	arbitrage. With corporate taxes at the rate
	T,but no personal taxes, the value of a	T1 (1T)(1T)
		cE
	c	g1T
	levered firm with static risk-free perpetual	D
	debt is the value of an otherwise
		Result 14.7:Assume there is a tax gain from leverage,
	equivalent unlevered firm plus the product
		but the taxable earnings of firms are low
	of the corporate tax rate and the market
		relative to their present values.
	value of the firm’s debt; that is
		•With riskless future cash flows, firms
	VV TD
	LUc	will want to use debt financing up to
Result 14.5:	Assume that the pretax cash flows of the	the point where they eliminate their
	firm are unaffected by a change in a	entire corporate tax liabilities, but
	firm’s capital structure, and that there are	they will not want to borrow beyond
	no transaction costs or opportunities for	that point.
	arbitrage. With corporate taxes but no	•With uncertainty, firms will pick the
	personal taxes, a firm’s optimal capital	debt ratio that weighs the benefits
	structure will include enough debt to	associated with the debt tax shield
	completely eliminate the firm’s tax	when it can be used against the
	liabilities.	higher cost of debt in cases where
Result 14.6:	Assume that the pretax cash flows of the	the debt tax shield cannot be used.
	firm are unaffected by a change in a	•Firms with more nondebt tax shields
	firm’s capital structure, and that there are	are likely to use less debt financing.
	no transaction costs of opportunities for
		Result 14.8:For low tax bracket investors, it is often
	arbitrage. If investors all have personal
		cheaper to lease an asset than to buy it.
	tax rates on debt and equity income of T
	D
	and T, respectively, and if the corporate
	E

Key Terms

accelerated depreciation524	Modigliani-Miller Theorem501
economic depreciation523	nondebt tax shields515
effective marginal tax rates518	operating lease523
financial lease (capital lease)523	true lease525
lessee-lessor523

Exercises

14.1.Suppose r12%, r10%, T33%, T14.2.Consider a single period binomial setting where

DEcD

20%.the riskless interest rate is zero, and there are no

a.What is the marginal tax rate on stock incometaxes. Afirm consists of a machine that will

Twhich would make an investor indifferent inproduce cash flows of $210 if the economy is

E

terms of after-tax returns between holding stockgood and $80 if the economy is bad. The good and

or bonds? Assume all betas are zero.bad states occur with equal risk-neutral probability.

b.What is the probability that a firm will notInitially, the firm has 100 shares outstanding and

utilize its tax shield if, on the margin, the firmdebt with a face value of $50 due at the end of the

is indifferent between issuing a little more debtperiod. What is the share price of the firm?

or equity?

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How Taxes Affect Financing Choices

527

14.3.Suppose the firm in exercise 14.2 unexpectedlypersonal portfolio? Assume the probability of

announces that it will issue additional debt, withbankruptcy is zero.

the same seniority as existing debt and a face14.8.During the early 1990s, most new airplanes were

value of $50. The firm will use the entire proceedsleased by the airlines. This was not true during the

to repurchase some of the outstanding shares.early and mid-1980s. Explain why.

a.What is the market price of the new debt?

14.9.Restaurant chains like McDonald’s sometimes

b.Just after the announcement, what will the price

franchise their restaurants and sometimes own

of a share jump to?

them outright. The franchised restaurants are

c.Show how a shareholder with 20 percent of the

usually owned by individuals who hold them in

shares outstanding is better off as a result of

subchapter S corporations which pass income

this transaction when he or she undoes the

through directly to the owners. There is no

leverage change.

corporate tax on this income, but the owner must

d.Show how the Modigliani-Miller Theorem still

pay personal taxes on the income.

holds.

a.From the perspective of the owner of the14.4.Assume that the real riskless interest rate is zerofranchise, is there a tax advantage to debt

and the corporate tax rate is 33 percent. IGWTfinancing?

Industries can borrow at the riskless interest rate.b.Which organizational form is better from the

It will have an inflation-adjusted EBITnext yearperspective of tax minimization: corporate

of $200 million. It would like to borrow $50ownership of the individual restaurants or

million today. Its only deductions will be interestfranchises?

payments (if any).

14.10.Real estate investment trusts (REITs) are

a.What are its interest payments, taxable income,

companies set up to manage investment properties

tax payments, and income left for shareholders

like office buildings and apartment houses. REITs

in a no-inflation environment?

are not subject to corporate taxes and are required

b.Suppose there is inflation of 10 percent per

to pass through 95 percent of their income to their

year, but the real interest rate stays at zero. This

shareholders who are taxed at the personal level.

means that investors now will require a sure

How do we expect taxes to affect the capital

payment of $1.10 next year for each $1.00

structure choice of REITs?

loaned today. Repeat part a,assuming that

14.11.X-Tex Industries has large depreciation tax

EBITis affected by inflation.

deductions and can thus eliminate all of its taxable

c.In which environment is the inflation-adjusted

income with a relatively small amount of debt. In

income left for shareholders higher? Why?

contrast, Unique Scientific Equipment14.5.As owner of 10 percent of ABC Industries, you

Corporation is generating a substantial amount of

have control of its capital structure decision. The

taxable income. Despite the tax advantage of debt,

current corporate tax rate is 34 percent and your

Unique uses only a modest amount of debt

personal tax rate is 31 percent. Assume that the

financing because the nature of its products would

returns to stockholders accrue as nontaxable

make financial distress very costly. Suppose the

capital gains. ABC currently has no debt and can

rate of inflation increased from 3 percent to 6

finance the repurchase of 10 percent of its

percent, increasing borrowing rates from 6 percent

outstanding shares by borrowing $100 million at

to 9 percent. How would this affect the optimal

the risk free rate of 10 percent. The AAA(tax-

capital structures of these two firms?

free) municipal bond rate is 8 percent. If you hold

14.12.Jeff started an Internet company, Finstrat.com,

your 10 percent of the firm constant and buy the

which, unlike others in the industry, generated

municipal bonds, what is your annual after-tax

taxable earnings almost immediately. Jeff owns 10

gain from this transaction?

percent of the shares, and the rest of the shares are14.6.Explain how inflation affects the capital structure

held by tax-exempt institutions. The firm needs to

decision. Does inflation affect the capital structure

raise $100 million in new capital. Jeff would like

choice differently for different firms?

to see the firm issue equity and would be willing14.7.Assume the corporate tax rate is 50 percent, AAAto purchase $10 million of the new equity to keep

corporate bonds are trading at a yield of 9 percent,his ownership stake constant. However, the

and municipal bonds are trading at a yield of 6institutions would like to see the firm raise the

percent. How can the shareholders of an AAA-capital through debt. Explain how part of this

rated firm gain by increasing the leverage of theirdisagreement might be related to taxes.

firm without increasing the leverage of their

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528Part IVCapital Structure

14.13.	ABC, Inc., financed with both equity and $10	past 8 years. The firm has hired the consulting
	million in perpetual debt, has pretax cash flow	firm of Stephanie & Chiara, LLC,to analyze the
	estimates for the current year as follows:	firm’s financing. The consulting firm recommends
		that the firm borrow $100 million (face value) in
	ProbabilityPretax Cash Flow
		perpetual riskless debt at (the current market
	0.3$1.5 million
		interest of) 10 percent and buy back $100 million
	0.5$2 million
		in equity. The founders, a team of brothers who
	0.2$4 million
		know pizzas very well, but not finance, explain
	The corporate tax rate is 40 percent, the effective	that taking on debt would reduce the earnings
	personal tax rate on equity is 20 percent, and the	available to equity each year by the amount of the
	interest rate on the perpetual debt is 10 percent. If	interest, thus reducing the value of the equity’s
	the expected after-tax cash flows to the debt	claim, and therefore would not benefit the
	holders, as a group, is the same as the expected	shareholders, most of whom are family and
	after-tax cash flows to the equity holders, as a	friends. Analyze the founder’s argument and
	group, what is the personal tax rate on debt?	compute the value of the debt tax shield proposed
		by Stephanie & Chiara assuming T0.14, T
14.14.	The Jack and Tyler Pizza Co.is financed entirely	ED
		0.28, and T0.34.
	with equity and has grown very quickly over the	C

References and Additional Readings

Asquith, Paul, and Thierry Wizman. “Event Risk,

Covenants, and Bondholder Returns in Leveraged

Buyouts.” Journal of Financial Economics27

(1990), pp. 195–213.

DeAngelo, Harry, and Ronald Masulis. “Optimal Capital

Structure under Corporate and Personal Taxes.”

Journal of Financial Economics8 (1980), pp. 3–29.Fisher, Irving. The Theory of Interest.1930. Reprint, New

York: Augustus Kelly, 1965.

Givoly, Dan; Carla Hayn; Aharon Ofer; and Oded Sarig.

“Taxes and Capital Structure: Evidence from Firm’s

Response to the Tax Reform Act of 1986.” Review of

Financial Studies5 (1992), pp. 331–55.

Graham, John. “Debt and the MTR,” Journal of Financial

Economics41 (1996), 41–73.

———. “How Big Are the Tax Benefits of Debt?”

Journal of Finance55 (2000), pp. 1901–41.

Graham, John, and Campbell Harvey. “The Theory and

Practice of Corporate Finance: Evidence from the

Field.” Journal of Financial Economics60 (May

2001), pp. 187–243.

Graham, John; Michael Lemmon; and James Schallheim.

“Debt, Leases, Taxes, and the Endogeneity of

Corporate Tax Status,” Journal of Finance53 (1998),

pp. 131–162.

MacKie-Mason, Jeffrey K. “Do Taxes Affect Corporate

Financing Decisions?” Journal of Finance45 (1990),

pp. 1471–95.

Miller, Merton. “Debt and Taxes.” Journal of Finance32

(1977), pp. 261–75.

Modigliani, Franco, and Merton H. Miller. “The Cost of

Capital, Corporation Finance, and the Theory of

Investment.” American Economic Review48, no. 3

(1958), pp. 261–97.

———. “Corporate Income Taxes and the Cost of

Capital: ACorrection.” American Economic Review

53, no. 3 (1963), pp. 433–92.

———. “AComment on the Modigliani-Miller Cost of

Capital Thesis: Reply.” American Economic Review

59, no. 4 (1969), pp. 592–95.

Titman, Sheridan, and Roberto Wessels. “The

Determinants of Capital Structure Choice.” Journal

of Finance43 (1988), pp. 1–20.

Warga, Arthur, and Ivo Welch. “Bondholder Losses in

Leveraged Buyouts.” Review of Financial Studies

6(1993), pp. 959–82.

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Chapter 14

How Taxes Affect Financing Choices

529

APPENDIX14A

HOWPERSONALTAXESAFFECTTHECAPITALSTRUCTURECHOICE:

THEMILLEREQUILIBRIUM

In his 1976 presidential address to the American Finance Association, “Debt and Taxes,” Mer-

ton Miller presented a model where, in equilibrium, firms are indifferent between financing their

new investments by issuing debt or issuing equity. This model is called the Millerequilibrium.

In the Miller equilibrium, equation (14.8) holds, so that the after-tax cost of debt equals the cost

of equity financing.

To understand Miller’s argument, we will first look at the demand by investors for debt and

equity instruments. We then consider the incentive of firms to supply these instruments. The

equilibrium in this market is determined at the point where the amount of debt and equity sup-

plied by firms equals the amount of each instrument demanded by investors at the instruments’

equilibrium rates of return.

To understand the Miller equilibrium, recall that if the pretax costs of debt and equity

(adjusted for risk premiums) are equal, debt is cheaper on an after-corporate tax basis. This is

the case considered in Chapter 13, where a firm’s weighted average cost of capital was shown

to decline as the firm added debt to its capital structure. In this case, if there are no offsetting

costs associated with debt financing, firms have an incentive to increase their debt levels and

will do so by issuing debt to repurchase their own shares.

As Exhibit 14A.1 illustrates, the Miller equilibrium assumes that the supply curve for debt,

the light blue line, is flat. Since Miller assumes that there are no costs associated with debt

financing (for example, no bankruptcy costs), firms will use debt financing exclusively if the

cost of debt, r(1T), is less than the cost of equity, r,and they will use equity financing

DcE

exclusively otherwise.

Tax-exempt investors are willing to invest their entire portfolio in debt as long as its zero-

beta expected rate of return exceeds the expected rate of return of zero-beta equity. The demand

EXHIBIT14A.1MillerEquilibrium

Rate of
return on debt
	1 – T E
	r D
	Demand for debt = r E 1 – T D

	Supply of debt
¯ r E
r D = (1 – Tc)

Dollar

value

of all

Amount held byTotal supplied in

debt

tax-exemptequilibrium

investors

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530Part IVCapital Structure

curve for debt, the dark blue line, would then be flat up to the point where the supply of funds

from tax-exempt investors is exhausted. To induce taxable investors to hold debt instruments, a

return premium must be offered because debt is a tax-disadvantaged instrument from their per-

spective. Hence, the demand curve slopes upward after the point at which the tax-exempt

investors are fully invested, reflecting the fact that investors in higher tax brackets require

increasingly higher debt returns to hold debt instead of equity.

To understand the Miller equilibrium, consider first the case where the pretax returns on zero-

beta debt and equity are the same. In this case, firms have an incentive to increase leverage and

will continue to replace equity with debt financing, moving up the demand curve by increasing

the return they offer as a group to debt investors until the after-tax cost of zero-beta debt equals

the cost of zero-beta equity. This point is reached at the intersection of the supply and demand

curves in Exhibit 14A.1.

In this equilibrium, the investor who is indifferent between holding debt and equity must have

tax rates that satisfy equation (14.4)

r(1 T) r(1 T),

DDEE

and the equilibrium rates from the supply curve

r(1 T) r

DcE

must be satisfied. By combining the above equations, we see that the tax rates for the indiffer-

ent investor satisfy

(1 T) (1 T)(1 T)

DcE

which makes Tzero. In other words, at the personal tax rates of the investor who is indiffer-

g

ent between holding debt and equity, there is no tax gain from leverage for the firm.

The conditions that must be satisfied for the existence of the equilibrium described above are

described in Result 14A.1.

Result 14A.1

(The Miller equilibrium.)If the following assumptions hold:

•	The interest deduction for debt always reduces taxes at the margin; that is, firms experience positive earnings after paying interest.
•	(1 T) is less than (1 T)(1 T) for some investors; that is, investors who DcE prefer equity to debt.
•	There are no costs such as bankruptcy costs associated with increasing debt levels.

Then in equilibrium, T0, that is, (1 T) (1 T)(1 T) and r(1T)r.

gDcEDcE

This implies that firms should be indifferent about leverage when both corporate taxes and

personal taxes are taken into account.

Discussion of the MillerEquilibrium.In the Miller equilibrium, the total supply of debt in

the economy is determined at the intersection of the supply and demand curves illustrated in

Exhibit 14A.1. However, the amount of debt supplied by each firm is a matter of indifference.

That such an important decision is a matter of indifference is not unusual in economics. Con-

sider a group of farmers who can produce either apples or oranges. If competition eliminates eco-

nomic rents from both products, the farmers will be indifferent about which product to produce.

However, consumer tastes will determine the mix of apples and oranges produced in the entire

economy. Similarly, in the Miller equilibrium, competition implies that the relative advantages

associated with issuing debt and equity securities vanish, making firms ultimately indifferent about

which to issue. Again, consumer tastes—in this case, investor tastes for receiving ordinary income

instead of capital gains—determine the mix of debt and equity in the economy as a whole.

Key Terms

Miller equilibrium529

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CHAPTER

How Taxes Affect Dividends

15and Share Repurchases

Learning Objectives

After reading this chapter, you should be able to:

1.Explain why, in the absence of personal taxes, there is an equivalence between

dividends and share repurchases and why tax-paying investors prefer a share

repurchase to a dividend payment.

2.Provide reasons for why firms pay taxed dividends instead of repurchasing shares.

3.Understand the difference between the classical tax system, which exists in the

United States, and the imputation system, which exists in a number of other

countries, and how these differences affect capital structures and dividend

policies.

4.Understand empirical evidence about how expected stock returns relate to

dividend yields.

5.Describe how personal taxes on dividend distributions can lead to distortions in

both investment and financing decisions.

At the end of 1994, Kirk Kerkorian held 32 million shares of Chrysler, representing

9.2 percent of Chrysler’s equity, and worth $1.57 billion. While Kerkorian expressed

“high regard” for the management of Chrysler, he found its most recent stock price

performance “very disappointing.” Indeed, although Chrysler’s stock price had

increased by almost 400 percent since Kerkorian first started buying the stock in

1991, it began to fall during the last three quarters of 1994. In November, Kerkorian

was quoted as saying: “It is essential that the company take positive steps to

enhance shareholder value.”¹

To understand Kerkorian’s disappointment, it is important to realize that

¹1

Chrysler’s stock price dropped from 63/in January 1994 to 45/in mid-November

28

1994. This drop represented a loss of $588 million for Kerkorian, which was more

than the value of his original investment.

¹“Kerkorian Pushes Chrysler to Improve Shareholder Value Update,” Bloomberg Business News,

Nov.14, 1994.

531

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532Part IVCapital Structure

Kerkorian’s major objection was that Chrysler had accumulated about $7.5 billion

in cash at the end of 1994, with projections of further cash increases to more than $8.6

billion by the end of 1995 and $11.3 billion by the end of 1996. Nevertheless, Chrysler

maintained that it needed the large cash reserves to “weather the next recession.”

In an effort to boost Chrysler’s stock price, Kerkorian proposed in November

1994 that Chrysler:

•	Boost its dividends.
••	Declare a two-for-one stock split. Undertake a stock repurchase plan.
•	Remove its poison pill takeover defenses and allow him to increase hisholdings.

Dividend policy, which specifies a firm’s policy about the distribution of cash to its

shareholders, is perhaps the topic which financial economists have the most trou-

ble discussing with corporate managers. Academics cite the Miller-Modigliani divi-

dend irrelevancy theoremwhich states that, except for tax and transaction cost con-

siderations, dividend policy is irrelevant. Corporate managers, however, who sometimes

spend long hours considering their dividend choices, think that this irrelevance propo-

sition is crazy. This difference of opinion persists despite numerous articles on the sub-

ject in professional and academic journals as well as academic forums that bring

together participants from both academia and business.

The communication gap between financial economists and corporate managers

stems, at least in part, from the fact that the two groups often consider different issues

when they think about dividend policy. When corporate managers talk about optimal

dividend policies, they are to a large extent really discussing the investment and cash

payout policies of their firms. Managers are asking whether earnings could be better

invested within the firm rather than outside the firm. They also think about how divi-

dend policies affect their leverage ratios, and about the trade-offs between financing

new investments with internally generated equity versus increasing dividends and fund-

ing the new investments with debt. In the Chrysler case described in this chapter’s open-

ing vignette, the company’s managers are presumably considering how much cash to

keep within the corporation and how much to distribute to shareholders.

Financial economists view the dividend choice from a narrower perspective, stress-

ing that a firm’s dividend choice need not be related to either its investment decisions

or its leverage decision. Financial economists believe that any analysis of a firm’s div-

idend policy should hold the firm’s investment decisions and its capital structure choice

constant. When they talk about Chrysler’s dividend policy, they assume that a certain

amount of cash will be paid out and ask whether Chrysler should distribute the cash

by paying a dividend or by repurchasing shares.

As this chapter later shows, when investment choices and leverage ratios are held

constant, the only alternative to paying a dividend is for the firm to use the funds to

repurchase shares. Hence, most of the academic literature on dividend policy consid-

ers the pros and cons of paying dividends versus repurchasing shares. For example, the

Miller-Modigliani dividend irrelevancy theorem does not say that the choice between

paying dividends and retaining the earnings to either pay off debt or to fund new invest-

ment is a matter of indifference. Rather, it merely says that, in the absence of tax and

transaction cost considerations, the way in which the earnings are distributed to share-

holders—that is, the choice between paying a dividend and repurchasing shares—does

not affect shareholders.

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Chapter 15

How Taxes Affect Dividends and Share Repurchases

533

This chapter analyzes how taxes and transaction costs affect the way firms dis-

tribute cash to their shareholders. It shows that share repurchases are the better alter-

native for most investors who must pay personal taxes. However, some tax-exempt

investors may prefer receiving cash distributions in the form of dividends because of

their lower transaction costs. The chapter also examines how personal taxes and trans-

action costs can make internally generated funds less expensive than externally gener-

ated funds. As a result, personal taxes and transaction costs affect how firms are

financed as well as how investment choices are made.²