Modigliani and Miller (1963) in their follow-up paper established the effects of taxes by relaxing the assumption that there are no corporate taxes. So corporations are allowed to deduct interest as an expense. Although the before tax and the net of tax approaches to the cost of capital provide equally good criteria for investment decisions when assets are assumed to generate perpetual streams of cash flow, such is not the case when assets are assumed to have finite lives . When assets are assumed to have finite life then correct method of determining the desirability of an investment would be to discount the net of tax stream at the net of tax cost of capital. Only under this net of tax approach would it be possible to take into account the deductibility of depreciation.
MM (1963) accepted that the net of tax approach is correct in principle but this encourages corporations to use 100 percent debt in their capital structure (Brigham and Ehrhardt). Off course this hundred percent debt policy was also discouraged by MM (1963) that the existence of a tax advantage for debt financing even the larger advantage does not necessarily mean that corporations should at all times seek to use the maximum possible amount of debt in their capital structures. For one thing, other forms of financing, like retained earnings may in some situation will be cheaper still when the tax status of investors under the personal income tax is taken into consideration. Off course no firm is going to obtain 100 percent financing by debt but theoretically their model proved that in the absence of bankruptcy cost it is possible.
However, this conclusion was modified several years later by Miller (1977) introducing personal as well as corporate taxes in the model. In addition to making the model more realistic, the revised approach adds considerable insight into the effect of leverage on value. In the real world firms do not observe 100% debt in their capital structure as the original MM model suggests.
Miller (1977) included personal income tax into account as well as corporation income tax then in this case gain from leverage, for the stockholders in a firm keeping real assets can be presented in the following way
Miller (1977) noted that when all tax rates are equal to zero the expression reduces to MM no tax result, and when personal income tax rate on income from bonds is the same as that on income from shares then the gain from leverage is the familiar . When tax rate on income from shares is less than the tax on income form bonds, then the gain from leverage will be less than .
If the personal income tax on stocks is less than the tax on income from bonds then the before tax return on bonds should be high enough, other things being equal to offset this disadvantage. Otherwise no investor would want to hold bonds. While it is true that owners of a leverage corporation are subsidized by the interest deductibility of debt, this advantage is counterbalanced by the fact that the required interest payments have already been grossed up by any differential that bondholders must pay on their interest income. In this way the advantage of debt financing may be lost.
If the rate of return on bonds supplied by corporations is Rd = Ro/ (1- ), then the gain form leverage will be zero. The supply rate of return equals the demand rate of return in equilibrium. If supply rate of return is less than Rd (1- ), then the gain from leverage will be positive, and all corporations would try to have a capital structure containing 100% debt. They will rush out to issue new debt; this is what was concluded in MM (1963) that 100 percent debt is possible. On the other hand, if the supply rate of return is greater than Ro/ (1- ), the gain from leverage will be negative and firms will take action to repay outstanding debt. Thus Miller (1977) suggested that taxable debt must be supplied to the point where the before tax cost of corporate debt must equal the rate that would be paid by tax free institutions grossed up by the corporate tax rate.
Millers argument has important implications for capital structure. First, the gain to leverage may be much smaller than what was previously thought. Consequently, optimal capital structure may be explained by a tradeoff between a small gain to leverage and relatively small costs such as expected bankruptcy costs. Second the observed market equilibrium interest rate is seen to be a before tax rate that is grossed up so that most or the entire interest rate tax shield is lost. Finally, Millers theory implies there is an equilibrium amount of aggregate debt outstanding in the economy that is determined by relative corporate and personal tax rates.
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