13: Capital Structure
4 Explain how Propositions I and II differ, as well as what they have in common.
5 What is the difference between levered and unlevered equity? What effect does substituting debt
for equity have on the required return on (levered) equity?
CONCEPT REVIEW QUESTIONS 13-2
13 -3 THE M&M CAPITAL STRUCTURE MODEL
WITH TAXES
M&M derived their propositions by assuming that companies operate in markets without taxes or
transactions costs. In this section, we look at what happens when we introduce corporate income taxes
and interest deductibility into the M&M framework.
13 -3a THE M&M MODEL WITH CORPORATE TAXES
In Australia and many other countries, companies can deduct interest payments to lenders as a business
expense. (Dividends paid to shareholders receive no similar tax advantage for the company.) The interest
deduction thus reduces the amount of taxes the company must pay to the government. Intuitively, this
should lead to a tax advantage for debt, meaning that managers can increase company value by issuing
debt. So, returning to our High-Tech Manufacturing Company (HTMC) example, we now demonstrate
how, with interest deductibility, adding debt to the company’s capital structure could increase the
company’s value by reducing the government’s tax claim on the company’s cash flow.
FIGURE 13.3 DO COMPANIES HAVE TARGET CAPITAL STRUCTURES?
Flexible
target
37%
Very strict
target
10%
Somewhat tight
target/range
34%
No target debt
ratio or range
19%
Source: Graham and Harvey (2001), ‘The Theory and Practice of Corporate Finance: Evidence From the Field,’ Journal of
Financial Economics, 60, pp. 187–243, copyright © 2001, with permission from Elsevier.