Chapter 13 Capital Structure and Leverage 421(^15) The situation here is similar to that involving tax-exempt municipal bonds versus taxable bonds.
(^16) John R. Graham, “How Big Are the Tax Bene! ts of Debt?” Journal of Finance, Vol. 55 (2000), pp. 1901–1941 and
“Estimating the Tax Bene! ts of Debt,” Journal of Applied Corporate Finance, Vol. 14, no. 1 (Spring 2001), pp. 42–54.
Because of the tax situation, Miller argued that investors are willing to accept
relatively low before-tax returns on stocks as compared to the before-tax returns
on bonds. For example, an investor in the 35% tax bracket might require a 10%
pretax return on Bigbee’s bonds, which would result in a 10%(1 # T) " 10%(0.65) "
6.5% after-tax return. Bigbee’s stock is riskier than its bonds, so the investor would
require a higher after-tax return (say, 8.5%) on the stock. Because the stock’s re-
turns (either dividends or capital gains) would be taxed at only 15%, a pretax
return of 8.5%/(1 # T) " 8.5%/0.85 " 10.0% would provide the required 8.5%
after-tax return. In this example, the interest rate on the bonds would be 10%, the
same as the required return on the stock, rs. Thus, the more favorable treatment of
income on the stock would cause investors to accept the same before-tax returns
on the stock and on the bond.^15
As Miller pointed out, (1) the deductibility of interest favors the use of debt
! nancing, but (2) the more favorable tax treatment of income from stocks lowers the
required rates of return on stocks and thus favors the use of equity. It is dif! cult
to specify the net effect of these two factors. However, most observers believe that
interest deductibility has a stronger effect and hence that our tax system favors
the corporate use of debt. Still, that effect is certainly reduced by the lower taxes
on stock income. Indeed, Duke University professor John Graham estimated the
overall tax bene! ts of debt! nancing.^16 He concluded that the tax bene! ts associ-
ated with debt! nancing represent about 7% of the average! rm’s value; so if a
leverage-free! rm decided to use an average amount of debt, its value would rise
by 7%.
We can observe changes in corporate! nancing patterns following major
changes in tax rates. For example, in 1993, the top personal tax rate on interest and
dividends was raised sharply, but the capital gains tax rate was not increased. This
resulted in a greater use of equity, especially retained earnings. Subsequent reduc-
tions in tax rates on both dividends and capital gains have continued the bene! ts
of equity! nancing over debt! nancing, which has continued the trend toward a
greater reliance on equity! nancing.
13-4b The Effect of Potential Bankruptcy
MM’s irrelevance results also depend on the assumption that! rms don’t go
bankrupt and hence that bankruptcy costs are irrelevant. However, in practice,
bankruptcy exists and it can be quite costly. Firms in bankruptcy have high legal
and accounting expenses; and they have a hard time retaining customers, sup-
pliers, and employees. Moreover, bankruptcy often forces a! rm to liquidate
assets for less than they would be worth if the! rm continued to operate. Assets
such as plant and equipment are often illiquid because they are con! gured to a
company’s individual needs and because they are dif! cult to disassemble and
move.
Note too that the threat of bankruptcy, not just bankruptcy per se, brings about
these problems. If they become concerned about the! rm’s future, key employees
start “jumping ship,” suppliers start refusing to grant credit, customers begin seek-
ing more stable suppliers, and lenders start demanding higher interest rates and
imposing stricter loan covenants.
Bankruptcy-related problems are likely to increase the more debt a! rm has in
its capital structure. Therefore, bankruptcy costs discourage! rms from pushing
their use of debt to excessive levels. Note too that bankruptcy-related costs have
two components: (1) the probability of their occurrence and (2) the costs that will
be incurred if! nancial distress arises. A! rm whose earnings are relatively volatile,