CP

Capital Structure Theory 489

. (13-6)

With a tax rate of about 40 percent, this implies that every dollar of debt adds about

40 cents of value to the firm, and this leads to the conclusion that the optimal capital

structure is virtually 100 percent debt. MM also showed that the cost of equity, rs,

increases as leverage increases, but that it doesn’t increase quite as fast as it would if

there were no taxes. As a result, under MM with corporate taxes the WACC falls as

debt is added.

Miller: The Effect of Corporate and Personal Taxes

Merton Miller (this time without Modigliani) later brought in the effects of personal

taxes.^11 He noted that all of the income from bonds is generally interest, which is

taxed as personal income at rates ( Td) going up to 39.1 percent, while income from

stocks generally comes partly from dividends and partly from capital gains. Further,

long-term capital gains are taxed at a rate of 20 percent, and this tax is deferred until

the stock is sold and the gain realized. If stock is held until the owner dies, no capital

gains tax whatever must be paid. So, on average, returns on stocks are taxed at lower

effective rates ( Ts) than returns on debt.

Because of the tax situation, Miller argued that investors are willing to accept rela-

tively low before-tax returns on stock relative to the before-tax returns on bonds. (The

situation here is similar to that with tax-exempt municipal bonds as discussed in Chap-

ter 4 and preferred stocks held by corporate investors as discussed in Chapter 5.) For

example, an investor might require a return of 10 percent on Strasburg’s bonds, and if

stock income were taxed at the same rate as bond income, the required rate of return

on Strasburg’s stock might be 16 percent because of the stock’s greater risk. However,

in view of the favorable treatment of income on the stock, investors might be willing

to accept a before-tax return of only 14 percent on the stock.

Thus, as Miller pointed out, (1) the deductibility of interestfavors the use of debt fi-

nancing, but (2) the more favorable tax treatment of income from stocklowers the required

rate of return on stock and thus favors the use of equity financing.

Miller showed that the net impact of corporate and personal taxes is given by this

equation:

. (13-7)

Here Tcis the corporate tax rate, Tsis the personal tax rate on income from stocks,

and Tdis the tax rate on income from debt. Miller argued that the marginal tax

rates on stock and debt balance out in such a way that the bracketed term in Equation

13-7 is zero, so VLVU, but most observers believe that there is still a tax advantage

to debt. For example, with a 40 percent marginal corporate tax rate, a 30 percent

marginal rate on debt, and a 12 percent marginal rate on stock, the advantage of debt

financing is:

.

(13-7a)

VU
0.25D

VLVU
c 1 

(10.40)(10.12)

(10.30)

dD

VLVU
c 1 

(1Tc)(1Ts)

(1Td)

dD

VLVU
TD

(^11) Merton H. Miller, “Debt and Taxes,” Journal of Finance32, May 1977, 261–275. Miller was president of
the American Finance Association, and he delivered the paper as his presidential address.

Capital Structure Decisions 485