What Now?

At this point we're still lacking any explanation for why we don't see firms going to 100% debt financing or paying zero taxes. In other words, we haven't identified any offsetting costs to adding debt to the capital structure. Merton (1977) identifies one potential cost.

Merton (1977):

• argued that we should ignore direct costs of bankruptcy because they're essentially trivial relative to the potential tax benefits
• recognized that taxes are also paid at the personal level

• personal tax rates on debt income are higher than personal tax rates on equity income
• tax benefits of debt at the corporate level are offset by the tax disadvantage of debt at the personal level

Taxes on debt and equity income:

1. Corporate debt
• interest is ordinary expense
• interest is ordinary income (assume par bond)
2. Equity
• dividends are ordinary income
• capital gains
• depends on time period
• not taxed if pushed into estate
• only realized capital gains taxed (time value benefit)

Consider a debt-for-equity swap in Merton's world:

• corporate tax liability goes down, but
• personal tax liability increases because investors holding more tax disadvantaged debt and less tax advantaged equity
• benefit of decreased corporate tax liability is exactly offset by the cost of increased personal tax liability

Aggregate and Firm Debt Levels (Merton)

Assume:

1. personal tax rate on stock income is zero
• required rate of return on equity equals the required rate of return on tax exempt securities, r_e=r₀
2. all bonds are riskless
3. no transactions costs
4. one corporate tax rate, t_c, across all firms
5. personal tax rate, t_p, varies across individuals

Firms indifferent between debt and equity when:

Investors' demand for debt is given by:

Note:

• Tax exempt entities have a comparative advantage in buying corporate debt.
• Marginal individual changes along demand curve

Miller's work brings us back to the conclusion that (even with taxes) financial policy is irrelevant.

Criticism: Miller abstracts from tax code

• DeAngelo and Masulis (1980)
• Brennan and Schwartz (1978)