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+ =
1
) 1 ( ) 1 (
1
Where:
T
S
= personal tax rate on equity income
T
B
= personal tax rate on bond income
T
C
= corporate tax rate
16-14
Personal Taxes: The Miller Model (cont.)
Thus the Miller Model shows that the value of a levered
firm can be expressed in terms of an unlevered firm as:
B
T
T T
V V
B
S C
U L
(
+ =
1
) 1 ( ) 1 (
1
- In the case where T
B
= T
S
, we return to M&M with
only corporate tax:
B T V V
C U L
+ =
16-15
Effect of Financial Leverage on Firm Value
with Both Corporate and Personal Taxes
Debt (B)
V
U
V
L
= V
U
+T
C
B when T
S
=T
B
V
L
< V
U
+ T
C
B
when T
S
< T
B
but (1-T
B
) > (1-T
C
)(1-T
S
)
V
L
=V
U
when (1-T
B
) = (1-T
C
)(1-T
S
)
V
L
< V
U
when (1-T
B
) < (1-T
C
)(1-T
S
)
B
T
T T
V V
B
S C
U L
(
+ =
1
) 1 ( ) 1 (
1
16-16
How Firms Establish Capital Structure
Most Corporations Have Low Debt-Asset Ratios.
Changes in Financial Leverage Affect Firm Value.
Stock price increases with increases in leverage and
vice-versa; this is consistent with M&M with taxes.
Another interpretation is that firms signal good news
when they lever up.
There are Differences in Capital Structure Across
Industries.
There is evidence that firms behave as if they had
a target Debt to Equity ratio.
16-17
Factors in Target D/E Ratio
Taxes
If corporate tax rates are higher than bondholder tax rates,
there is an advantage to debt.
Types of Assets
The costs of financial distress depend on the types of
assets the firm has.
Uncertainty of Operating Income
Even without debt, firms with uncertain operating income
have high probability of experiencing financial distress.
Pecking Order and Financial Slack
Theory stating that firms prefer to issue debt rather than
equity if internal finance is insufficient.