Introduction to Corporate Finance

13: Capital Structure

answer to this question is that non-tax factors partly offset the tax benefits of debt usage. Another part

of the answer is that personal income taxes can cancel out some or all of the corporate-level tax benefits

of debt usage.

In 1977, Merton Miller developed a valuation model that incorporated both corporate and personal

taxes.^7 Rather than using Equation 13.4, Miller provided a formula for computing the gains from using

leverage, Gl, both for individual companies and for the corporate sector as a whole:

Eq. 13.6 Gl

TT

T

1

11

1

D

Cps

pd

()

()

()

= −

−−

−

















×

where

■ Tc = tax rate on corporate profits, as before

■ Tps = personal tax rate on income from equity (dividends and capital gains)

■ Tpd = personal tax rate on income from debt (interest income)

■ D = market value of a company’s outstanding debt.

This is, in fact, a very general formulation. In a no-tax world (Tc = Tps = Tpd = 0), the gains from

leverage equal zero, and the original M&M irrelevance proposition holds. (See if you can verify this

yourself.) In a world with only corporate income taxes (Tc = 0.35; Tps = Tpd = 0), Gl = Tc × D, and the

100% optimal debt result again emerges. If, however, personal tax rates on interest income are sufficiently

high, and personal tax rates on equity income are sufficiently low, the gains to corporate leverage can be

dramatically reduced, or even offset entirely.

Here is an alternative outcome. In Australia, the rate Tps for Australian tax residents is set by formula

to equal [(Tpd – Tc)/(1 – Tc)], by the dividend imputation tax scheme. That is, the personal tax rate on

income from equity is not a fixed number, but a formula with a value that changes as the corporate profit

tax rate and the debt income tax rate change. In words, the impact of the dividend imputation tax regime

is a scheme in which some or all of the tax paid by a company may be attributed to shareholders in the

form of a tax credit to reduce income tax payable on the income distribution (dividend).

If the value of Tps is given by the formula in the previous paragraph, then the term in square brackets

in Equation 13.6 is [1 – 1] (check the algebraic effect by substitution); so no gain occurs from using

leverage. Several countries, such as the UK, Canada and New Zealand, use a form of this dividend

imputation scheme, and similarly can reduce the impact of leverage on the value of company.

6 What effect does incorporating corporate income taxation have on the M&M capital structure

irrelevance hypothesis? Why?

7 What share price effects do you think resulted from the 1987 introduction of the dividend

imputation tax for Australian companies?

CONCEPT REVIEW QUESTIONS 13-3

7 See Merton Miller, ‘Debt and Taxes’, Journal of Finance 32 (May 1977), pp. 261–76.