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Tax effect towards an Optimal Debt/Equity Ratio for firms: A critical evaluation.
Corporate Finance: CB8020
Critical statement: The tax advantage of debt in comparison with equity is fully eliminated in a world with personal and corporate taxes leading to the acceptance of Miller-Modigliani proposition, therefore firms should stop worrying about finding an optimal D/E mix and concentrate on their businesses. Author: H.T.Y. Ng
Kent Business School, University of Kent, Canterbury CT7 2PE, United Kingdom

1. Introduction The Miller-Modigliani theorem (1958) states two main propositions when determining the relationship between a firms value and its leverage. In a perfect and efficient market, Proposition I suggests that the value of a firm remains unchanged regardless of the manner in which the firm alters its debt or equity financing ratio. Increasing debt does not add value to the firm. Proposition II suggest that the rate of return of equity, or cost of equity, increases simultaneously with the firms leverage. However, when corporate taxes are reintroduced into the theorem with all other assumptions held constant, MMs propositions undergo changes. Proposition I suggests that because the present value of interest on debt are not taxed, this provides a tax-shield incentive for firms where it pays to borrow; consequently, the firms value increases as it tackles additional debt. Proposition II continues to hold, as the cost of equity rises, however introduction of the riskless corporate interest tax shield reduces the cost. Lastly, when personal taxes are also reintroduced in conjunction with corporate taxes, they may or may not offset the advantages of taking on higher debt. Interest income from debt, alongside capital gains and dividends, are taxable on a personal level for bond (debt) and share (equity) holders respectively. Hence, when

critically evaluating whether tax advantages of debt are fully eliminated at the time personal and corporate taxes are introduced, this arguably may not be the case. Furthermore, if tax advantages from debt leveraging are fully eliminated, this should not inevitably result in firms discontinuing their search of its optimal debt to equity ratio. Beyond taxation benefits, a firms decision to employ additional structured debt or equity holdings is followed by two other vital factors; business and financial risk. The acceptance of Miller-Modiglianis propositions requires extremely strong market assumptions to be made, which in reality have very little practical application. Evidence from the empirical studies from Graham, Land, and Shackelford (2003), DeAngelo and Masulis (1980) and a deeper look into a firms financial distress and bankruptcy costs, leads to the rejection of the Miller-Modigliani propositions applicability in real world scenarios. Frank & Goyals (2007) take on Trade-off and Pecking Order theory proves that optimal debt to equity ratio does exist and firms should evaluate costs and benefits of various leverage plans. This paper will thus focus on [1] whether the tax advantage of debt in comparison to equity is truly fully eliminated, [2] whether or not firms attempt to determine an optimal debt to equity ratio, and [3] prove whether [1] directly causes [2] to occur.

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Hypothesis: [1] The tax advantage of debt is not fully eliminated when personal and corporate taxes are accounted for, [2] that firms care and do try to determine an optimal D/E capital structure which balances cost of debt factors marginal to a gain in a firms value and [3], [1] does not directly prove [2]. Simply put, hypothesis [3] suggests that the tax advantage of debt is not the sole determinant in a firms bid to obtain an optimal D/E structure. If any of [1, 2, 3] is proven correct, the essays critical statement would be proven invalid and should either be modified or rejected. 2. Personal and Corporate Taxes Effects On Debt Financing The Miller-Modigliani theorem suggests firms in a world without taxes should be indifferent when choosing between debt and equity financing. However, with the introduction of personal and corporate taxes, the objective of the firm then becomes the maximum minimization of the firms tax payable. This gives debt financing an advantage over equity. What must not be overlooked however is that personal taxes are biased on equity returns and are in fact lower than taxable interest payments on bonds. Stockholders income from equity comes in the form of capital gains and dividend payments. Based on the existing U.S. tax code, capital gains are often taxed at a lower rate than bonds and the tax is deferred until the stock is sold and the gain is realized on balance, common stock returns are taxed at lower rates than debt returns. (Talmor, Haugen, Barnea, 1985) This results in an offset of the corporate taxation. Miller (1977) argues, Taking personal as well as corporate taxation into account eliminated any net tax advantage of debt finance. From this logic, it can be deduced that a firms capital structure (its D/E ratio) should be random, regardless of how much debt or equity the company holds. However, empirical evidence tends to suggest otherwise. The tax advantage from debt does not only surface in the form of reduced tax on profits payable. Tax shield not only comes in the form of interest charges but as well as non-debt tax shield which include tax credit, transfer pricing, depreciation, option deduction and many more. (Graham, 2003). Evidence here implies nondebt tax shield (NDTS) is an unaccounted variable in Millers (1963) argument. In their research, DeAngelo and Masulis (1980) pointed out that companies that used debt to repurchase equity saw an increase in equity value by a few percentage points. This effectively exhibited that debt does in fact bring in value to the firm and that the net advantages of debt are not fully eliminated contrary to MMs propositions. The research of Graham, Lang, and Shackelford (2003) proclaimed that option deduction, which is one of NDTS factors, helped reduce the tax rate of large firms from 34% to 26%. Similarly, a surge in tax rates caused firms debt policies to increase. 3. Cost of Debt Factors Assuming that hypothesis [1] is held true, firms should thus employ as much debt to maximize their value. Contrariwise, the cost of debt factors such as financial distress, bankruptcy cost, and agency cost lead to theories such as trade-off, and pecking order theory that show why firms employ an optimal debt to equity ratio, which prevents firms from maximizing their value through fully leveraging. Kims (1978) research concluded a firms value would increase when it employs debt in its capital structure but only to a certain extent. Debt capacity occurs at less than one-hundredpercent debt financing and firms do have optimal capital structures which involve less debt financing than their debt capacities market value of the firm increases for low levels of debt and decreases as financial leverage becomes extreme. (Kim, 1978). Kraus and Litzenberger (1973) uses trade-off theory to balance the tax benefits of debt financing with the burdening costs of bankruptcy which Frank and Goyle (2007) agree are the two most prominent variables which firms employ in their capital structuring process. Thus, a value-maximizing firm would not pass up interest tax shields when the probability of financial distress is low,

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supporting the notion that firms do try to find an optimal debt to equity ratio. The pecking order theory (Myers, 1984), recognizes that a firms internal uses of financing are not perfect substitutes for external financing in a world where asymmetric information between managers and investors exists. The types of financing preferred by management imply that retained earnings are better than debt and debt is better than equity (Frank and Goyle, 2007). Through this financing hierarchy, how a firm chooses to finance its capital structure may signal to investors the firms health due to asymmetric information. Bearing this in mind, a highly profitable firm may then have lower leverages as a result and vice versa. Thus, a firms capital structure is important and how it acquires financing plays a vital role and should not be abruptly ignored. The pecking order theory also supports hypothesis [3] as it is not the tax advantage of debt, but rather the asymmetric information derived which causes firms to employ optimal D/E capital policies. Agency costs in the form of asset substitution, underinvestment, and free cash flow push firms to find an optimal capital structure. As firms acquire more debt, management may even undertake negative NPV projects since debt holders bare all downsides if unsuccessful and vice versa for shareholders if successful. (Leland, 1996) Underinvestment on the other hand occurs when management may reject positive NPV projects as debt is perceived as too risky as any positive gain would be received by debt holders rather than shareholders. (Harris, 1991) Agency cost from free cash flow stems from management incentive to push firms to grow beyond their optimal size, as this growth increases managers power by increasing the resources under their control. (Jensen, 1986) Use of debt leveraging could then minimize these agency costs within the firm, and thus careful consideration of a firms capital structure is again employed. Scotts (1976) model of debt, equity, and firm valuation further validates hypothesis [2]. The author found the debt level a firm chooses to employ depends on a variety of factors. The author established there was an increasing function in relation with the size of the company, its liquidity, and the level of corporate tax rate. Larger firms are able to swallow larger debts while more liquid companies are able to issue new structured debt without a high offset in bankruptcy cost. The higher the corporate tax rate, the more incentive for firms to utilize the tax shields of debt indicating an optimal internal capital structure exists and is important to firms. 4. Tax Advantages of Debt and Capital Structure: not the only parallel Empirical evidence from Masulis (1980) suggests tax advantage benefits of debt do exist and firms have already been in practice of using an optimal debt to equity capital structure. Masulis tax hypothesis suggests that leverage increasing exchange offers increase equity value by 7.6% and leverage-decreasing transactions decrease value by 5.4% the coefficient of stock returns to a change in debt is approximately 0.40 (Graham, 2003). This demonstrates that when firms do take on additional debt, a relationship between a firms value and its leverage does exist. This has earned notable replies from the likes of Myers (1984) and Cornett and Travlos (1989) whom argued that Masuliss results may be derived from nontax factors which affect the exchange offer returns (Graham, 2003) rather than the corporate tax-shield incentive being the main contributing factor. Analysis on the implications of taxinduced differential returns that emerge as investors face personal taxes on interest income shows that tax arguments are insufficient to explain interior capital structures. (Talmor, Haugen, Barnea, 1985). Moreover, pecking order theory and agency costs covered in section 3 offers evidence that tax shield benefits are not the sole factors which firms consider when employing the level of leverage to use in its capital structuring policies.

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5. Conclusion According to the M&M model, capital structure of a firm is argued irrelevant in a perfect and efficient market. Thus, market imperfections applicable in reality ergo are the cause of its relevance. Empirical evidence from Graham, Lang, Shackelford (2003) and Grahams (2003) inclusion of NDTS, suggest that hypothesis [1] cannot be fully rejected, yet at the same time, the evidence itself opens up to a major flaw. The lack of a quantifiable way to measure the direct causality that a surge in tax rates is what caused debt policies to rise is a problematic. Its linear relationship correlation is high but is hard to test. Thus the papers hypothesis [1] cannot be fully proven nor disproven. But given that hypothesis [1] is held true, the theories of trade-off, pecking order, and agency costs tries to relax some of the strong assumptions made in the M&M model. Hypothesis [2] is proven through the help of the above theories. Firms care and do try to determine an optimal D/E capital structure as trade-off theory rationalizes the differences in debt to equity ratios between industries through the marginal benefits of debt leveraging. Pecking order attempts quantify the cost of asymmetric information derived from the hierarchy of internal and external financing. In doing so, the theory supports that firms D/E ratios are vital in conveying the right signals to investors. Leland (1996), Harris (1991), and Jensens (1986) argument of agency costs goes to further support hypothesis [2] and that optimal D/E ratio minimizes costs of asset substitution, underinvestment, and abuse of free cash flows by management. Hypothesis [3] is proven correct as the evidence for hypothesis [2] strongly supports that it is not only tax advantages that is the sole factor in a firms decision to find and employ optimal D/E capital structure. With strong evidence from trade-off theory that emphasizes taxes, pecking order theory on the differences in information and agency costs of management with debt leveraging to support hypothesis [2,3], the essays critical statement has be proven invalid and should either be modified or rejected. Ultimately, the paper hopes see further research in the future that addresses how to quantitatively link the connection that proves hypothesis [1].

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