Capital Structure Theories^279
In terms of the corporate borrowing, Millerís model [Equation (25)] indicates the
following. If the personal tax rate on equity income is zero, except the tax-exempt debt-
holders, nobody would be interested in lending to the firm. But, from the firmís point,
there is a strong incentive to borrow as the corporate taxes are reduced. Therefore,
to induce debt-holders to lend to the firm, the firm will have to offer a higher before-
tax interest rate. This implies that if the rate on the debt of tax-exempt investors is, say,
I, then debt-holders with a personal tax rate of Tpb, will have to be at least offered a
rate of interest equal to i 0 /(1 - Tpb), otherwise they will not lend. The personal income
tax system is generally progressive. Therefore, the firms will have to keep the interest
rate rising to attract investors in high tax brackets. Firms will be motivated to keep the
interest rate rising if the corporate tax saving is greater than the personal tux loss. They
will stop borrowing once the-corporate tax rate, T, equals the personal tax rate, Tpb.
Thus, in the equilibrium, the interest rate should be equal to: i 0 /(l-T). Let us verify this
point. Assume that the personal tax rate on equity income is zero:
Tpe = 0, then Equation (25) can be written as follows:
PVINTS =
= - -
...(26)The advantage from leverage will become zero once the interest rate offered (i.e., the
supply rate) becomes equal to tax exempt rate grossed up for taxes, is = i 0 (1-T). The
supply rate is is equal to the demand rate id, in equilibrium:
^ ^
= == ...(27)
and consequently, (1 - T) = (1 - Tpb), and PVINTS = 0. If is < i 0 (l - T), the PVINTS
0 and firms will attempt to reach 100 per cent debt in their capital structures. This
is shown in Figure 11.3.
Millerís model has two important implications:
l There is an optimum amount of debt in the economy which is determined by the
corporate and personal tax rates. In other words, there is an optimum debt-
equity ratio for all firms in the economy.
l There is no optimum debt-equity ratio For a single firm. There are hundreds of
firms which have already induced ëtax-exemptíí and ëlow lax bracketí investors.
Therefore, a single firm can-not gain or lose by borrowing more or less.
Millerís model has certain limitations:
l It implies that tax-exempt persons/institutions will invest only in debt securities
and ëhigh-tax bracketí investors in equities.In practice, investors hold portfolio
of debt and equity securities.