DEBT AND TAXES Finanzas Corporativas

MERTON H. MILLER Carlos Arango

SCHEDULE
1. Objective
2. Bankruptcy costs in perspective
3. An important case: income bond
4. Taxes and capital structures: the empirical record
5. The tax advantages of debt financing reexamined
6. Special cases
7. Taxes and market equilibrium
8. Properties of market equilibrium
9. Conclussions
OBJECTIVE
Trying to establish the propositions about valuation implied
by the economist's basic working assumptions of rational
behavior and perfect markets.

He will argue that even in a world in which interest

payments are fully deductible in computing corporate
income taxes, the value of the firm, in equilibrium will still
be independent of its capital structure.
BANKRUPTCY COSTS IN
PERSPECTIVE
Bankruptcy costs and agency costs do indeed exist as was dutifully
noted at several points in the original 1958 article. It is just that
these costs, by any sensible reckoning, seem disproportionately
small relative to the tax savings they are supposedly balancing.
The tax savings, after all, are conventionally taken as being on the
order of 50 cents for each dollar of permanent debt issued.3 The
figure one usually hears as an estimate of bankruptcy costs is 20
percent of the value of the estate.
But when that figure is traced back to its source in the paper by
Baxter it turns out to refer mainly to the bankruptcies of
individuals, with a sprinkling of small businesses, mostly
proprietorships and typically undergoing liquidation rather than
reorganization.
BANKRUPTCY COSTS IN
PERSPECTIVE
Warner tabulated the direct costs of bankruptcy and reorganization for a sample of
11 railroads that filed petitions in bankruptcy under Section 77 of the Bankruptcy Act
between 1930 and 1955. He found that the eventual cumulated direct costs of
bankruptcy-and keep in mind that most of these railroads were in bankruptcy and
running up these expenses for over 10 years!-averaged 5.3% of the market value of
the firm's securities as of the end of the month in which the railroad filed the
petition. There was a strong inverse size effect, moreover. For the largest road, the
costs were 1,7%.
And remember that these are the ex post, upper-bound cost ratios, whereas, of
course, the expected costs of bankruptcy are the relevant ones when the firm's
capital structure decisions are being made. On that score, Warner finds, for example,
that the direct costs of bankruptcy averaged only about 1 percent of the value of the
firm 7 years before the petition was filed; and when he makes a reasonable
allowance for the probability of bankruptcy actually occurring, he comes up with an
estimate of the expected cost of bankruptcy that is, of course, much smaller yet.
BANKRUPTCY COSTS IN
PERSPECTIVE
Warner's data cover only the direct costs of reorganization
in bankruptcy. The deadweight costs of rescaling claims
might perhaps loom larger if measures were available of
the indirect costs.
Why speculate about the size of these costs?
AN IMPORTANT CASE:
INCOME BOND
Interest payments on such bonds need be paid in any year
only if earned; and if earned and paid are fully deductible in
computing corporate inconmetax. But if not earned and not
paid in any year, the bondholders have no right to
foreclose. The interest payments typically cumulate for a
short period of time-usually two to three years-and then are
added to the principal. Income bonds, in sum, are securities
that appear to have all the supposed tax advantages of
debt, without the bankruptcy cost disadvantages.
In sum, the great emphasis on bankruptcy costs in recent
discussions of optimal capital structure policy seems to me
to have been misplaced.
TAXES AND CAPITAL
STRUCTURES: THE EMPIRICAL
RECORD
If the optimal capital structure were simply a matter of balancing
tax advantages against bankruptcy costs, why have observed
capital structures shown so little change over time?
First observation in 1960 under the auspices of the Commission on
Money and Credit:
I found, among other things, that the debt/asset ratio of the typical
nonfinancial corporation in the 1950's was little different from that
of the 1920's despite the fact that tax rates had quintupled-from 10
and 11 percent in the 1920's to 52 percent in the 1950's
TAXES AND CAPITAL
STRUCTURES: THE
EMPIRICAL RECORD
Such rise as did occur, moreover, seemed to be mainly a
substitution of debt for preferred stock, rather than of debt
for common stock. The year-to-year variations in debt ratios
reflected primarily the cyclical movements of the economy.
During expansions debt ratios tended to fall, partly because
the lag of dividends behind earnings built up internally
generated equity; and partly because the ratio of equity to
debt in new financings tended to rise when the stock
market was booming.
TAXES AND CAPITAL
STRUCTURES: THE EMPIRICAL
RECORD
Some upward drift in debt ratios did appear to be taking place in
the 1960's, at least in book-value terms
Some substantial portion of this seeming rise, however, is a
consequence of the liberalization of depreciation deductions in the
early 1960’s
An accounting change of that kind reduces reported taxable
earnings and, barring an induced reduction in dividend policy,
Will tend to push accumulated retained earnings (and total assets)
below the levels that would otherwise have been recorded
Thus, without considerable further adjustment, direct comparison
of current and recent debt ratios to those of earlier eras is no
longer possible.
TAXES AND CAPITAL
STRUCTURES: THE
EMPIRICAL RECORD
The increases in debt of such concern in 1974 can be seen
to be a transitory response to a peculiar configuration of
events rather than a permanent shift in corporate capital
structures.

A surge in inventory accumulation was taking place as firms

sought to hedge against shortages occasioned by
embargoes or price controls or crop failures. Much of this
accumulation was financed by short-term borrowing-a
combination that led to a sharp deterioration in such
conventional measures of financial health as "quick ratios"
and especially coverage ratios
TAXES AND CAPITAL
STRUCTURES: THE
EMPIRICAL RECORD
But this inventory bubble burst soon after the famous
doomsday issue of Business Week hit the stands

And since failure to close the gap cannot convincingly be

attributed to the bankruptcy costs or agency costs of debt
financing, there would seem to be only one way left to turn:
the tax advantages of debt financing must be substantially
less than the conventional wisdom suggests
THE TAX ADVANTAGES OF DEBT
FINANCING REEXAMINED
 
When the personal income tax is taken into account along
with the corporation income tax, the gain from leverage, GL,
for the stockholders in a firm holding real assets can be
shown to be given by the following expression:

All the taxes are assumed to be proportional,

And to maintain continuity with the earlier MM papers, the
expression is given in its "perpetuity"form
SPECIAL CASES:
 
When all tax rates are set equal to zero, the expression
does indeed reduce to the standard MM no-tax result of
When the personal income tax rate on income from bonds is
the same as that on income from shares-a special case of
which, of course, is when there is assumed to be no
personal income tax at all-then the gain from leverage is
the familiar
When the tax rate on income from shares is less than the
tax on income from bonds, then the gain from leverage will
be less than
For a wide range of values for and the gain from leverage
vanishes entirely or even turns negative!
The gain evaporates or turns into a loss because investors hold
securities for the "consumption possibilities" they generate and hence
will evaluate them in terms of their yields net of all tax drains
If, therefore, the personal tax on income from common stocks is less
than that on income from bonds, then the before-tax return on taxable
bonds has to be high enough, other things equal, to offswt this tax
handicap. Otherwise, no taxable investor would want to hold bonds.
Thus, while it is still true that the owners of a levered corporation have
the advantage of deducting their interest payments to bondholders in
computing their corporate income tax, these interest payments have
already been "grossed up," so to speak, by any differential in the taxes
that the bondholders will have to pay on their interest income.
 
When the rates happen to satisfy the equation the offset is
one-for-one and the owners of the corporation reap no gain
whatever from their use of tax-deductible debt rather than
equity capital.
Any situation in which the owners of corpora- tions could
increase their wealth by substituting debt for equity (or
vice versa) would be incompatible with market equilibrium.
Their attempts to exploit these opportunities would lead, in
a world with progressive income taxes, to changes in the
yields on stocks and bonds and in their ownership patterns.
These changes, in turn, restore the equilibrium and remove
the incentives to issue more debt, even without invoking
bankruptcy costs or lending costs as a deus ex machina.
TAXES AND MARKET
EQUILIBRIUM
Suppose, for simplicity that the personal tax rate on income
from stock were zero
Suppose that all bonds are riskless and that there are no
transaction costs, flotation costs or surveillance costs
involved in their issuance :
TAXES AND MARKET
EQUILIBRIUM
 
To entice these taxable investors into the market for
corporate bonds, the rate of interest on such bonds has to
be high enough to compensate for the taxes on interest
income under the personal income tax.
The intersection of this demand curve with the horizontal
straight line through the point , i.e., the tax-exempt rate
grossed up by the corporate tax rate, determines the
market equilibrium.
If corporations were to offer a quantity of bonds greater
than B*, interest rates would be driven above and some
levered firms would find leverage to be a losing proposition.
If the volume were below B*, interest rates would be lower
than and some unlevered firms would find it advantageous
PROPERTIES OF MARKET
EQUILIBRIUM
There will be an equilibrium level of aggregate corporate
debt, B*, and hence an equilbrium debt-equity ratio for the
corporate sector as a whole.
But there would be no optimum debt ratio for any individual
firm. Companies following a no-leverage or low leverage
strategy (like I.B.M. or Kodak) would find a market among
investors in the high tax brackets; those opting for a high
leverage strategy (like the electric utilities) would find the
natural clientele for their securities at the other end of the
scale.
And in this important sense it would still be true that the
value of any firm, in equilibrium, would be independent of
its capital structure, despite the deductibility of interest
payments in computing corporate income taxes.
IF THE STOCKHOLDERS OF LEVERED CORPORA-
TIONS DON'T REAP THE BENEFITS OF THE TAX
GAINS FROM LEVERAGE, WHO DOES?

Universities and other tax exempt organizations, as well as

individuals in low tax brackets benefit from what might be
called a "bondholders' surplus."
Market interest rates have to be grossed up to pay the
taxes of the marginal bondholder, whose tax rate in
equilibrium will be equal to the corporate rate.
Low bracket individuals (and corporations) have to pay the
corporate tax, in effect, when they want to borrow.
An equilibrium of the kind pictured in Figure 1 does not
require, of course, that the effective personal tax rate on
income from shares of the marginal holder be literally zero,
but only that it be substantially less than his or her rate on
income from bonds.
MARKET EQUILIBRIUM AND THE
BEHAVIOR OF FIRMS AND
INDIVIDUALS
CONCLUSSIONS:
To say that many, perhaps even most, financial heuristics
are neutral is not to suggest, however, that financial
decision making is just a pointless charade or treat the
resources devoted to financial innoviations are wasted.
Neutral mutations that serve no function, but do no harm,
can persist indefinitely.
A mutation or a heuristic that is neutral in one environment
may suddenly acquire (or lose) survival value if the
environment changes.