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(^274) Financial Management
T is the corporate tax rate and L is debt ratio. The levered firmís cost of capital is
shown in Figure.
The M-Mís ëtax-correctedí view suggests that, because of the tax deductibility of
interest charges, a firm can increase its value or lower its cost of capital continuously
with leverage. Thus the optimum capital structure is reached when the firm employs
100 per cent debt. But the observed experience does not entirely support this view. In
practice, firms do not employ large amounts of debt, nor are lenders ready to lend
beyond certain limits. M-M suggest that firms would adopt a target debt ratio so as not
to violate the limits of the debt level imposed by lenders. They state:
..... existence of a tax advantage for debt financing does not necessarily mean
that corporations should at all times seek to use the maximum possible amount
of debt in their capital structures... (T) here are, as we pointed out, limitations
imposed by lenders, as well as many other dimensions in real-world problems
of financial strategy which are not fully comprehended within the framework of
static equilibrium models... These additional considerations, which are typically
grouped under the ruberic of the need for preserving flexibility, will normally
imply the maintenance by the corporation of a substantial reserve of untapped
borrowing power.
Why do companies not employ extreme level of debt in practice? There could be two
possibilities: First, we need to consider the impact of both corporate and personal taxes
for corporate borrowing. Personal income tax may offset the advantage of the interest
tax shield. Second, borrowing may involve extra costs (in addition to contractual
interest cost)-costs of financial distressówhich may also offset the advantage of the
interest shield. Let us examine these points in the following section.
Economy-wide Optimum Capital Structure: Millerís
Hypothesis with Corporate and Personal Taxes
Investors are required to pay personal taxes on the income earned by them. Therefore,
from investorís point of view, taxis will include both corporate and personal taxes. A
firm should thus aim at minimising the total taxes (both corporate and personal) while
deciding about borrowing. How do personal income taxes change investorís return and
value? It depends on the corporate tax rate and the difference in the personal income
tax rates of investors.
Consider an example. In Illustration 6 of firms L and U, let us add information about
the personal taxes. Assume that both shareholders and lenders are required to pay 40
per cent tax on their incomeórespectively dividends and interest. The after-tax income
accuring to investors is shown in Table