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(^280) Financial Management
Figure 11.3: Aggregate supply and demand for borrowoing
l The personal tax rate on equity income is not zero. Firms do pay dividends. If
Tpe is positive, more investors can be induced to hold debt securities. Assume
T = 0.25 and T = 0.5. Then the total tax on equity income is: 0.5 + 0.25 (1 - 0.5)
= 0.625 or 62.5 per cent. More debt can be raised until investors in 62.5 per cent
tax brackets are covered.
l Investors in high-tax brackets can be Induced to invest in debt securities indirectly.
They can invest in those institutions wherefrom income is tax exempt. These
institutions, in turn, can invest in the corporate bonds.
We can summarise our discussion of M-Mís and Millerís models as follows. Under M-
Mís model, the existence of the corporate taxes provide a strong incentive to borrow.
In fact, it is ideal for a firm to have 100 per cent debt in its capital structure. They ignore
personal taxes. Millerís model considers both the corporate as well as the personal
taxes. It concludes that the advantage of corporate borrowing is reduced by the
personal tax loss. The important implication of the model is that there is no optimum
capital structure for a single firm, although for the economy as a whole, there does exist
equilibrium amount of aggregate debt. From a single firmís point of view, therefore, the
capital structure does not matter. Millerís model is based on some controversial
assumptions, and therefore, most people still believe that in balance, there is a tax
advantage to corporate borrowing.
Financial Distress
We have argued earlier that it is difficult to believe that a firm should have 100 per cent
debt because of tax advantage. Why donít firms in practice borrow 100 per cent?
What are the offsetting disadvantages of debt? The offsetting disadvantages are
grouped under the term financial distress. A firm exposeh to higher business risk faces
a greater chance of financial distress. The business risk of a firm depends on operating
risk, intensity of competition, price elasticity, economic conditions, the size of the firm,
i/(1-T)s is = i^0 /(1-T)
i 0
o Amount of borrowing
id = i 0 /(1-Tpb)
Demand
Supply