Taxes and the Optimal Capital Structure

1.   Introduction

In 1958, Modigliani and Miller introduced the capital structure theory, which states that the capital structure does not affect the value of a firm. However, The presence of corporate taxes contributes to the existence of the optimal capital structure. The company could obtain the advantage of having debt for its capital structure, because “interest paid on debt is tax deductible” (Ross, Westerfield, & Jordan, 2006:p.547). In 1963, Modigliani and Miller developed their theory as a consideration of the presence of corporate taxes. Their capital structure theory with taxes states that the value of a firm increases as the total debt increases. Nevertheless, the presence of personal taxes also should be considered. Miller (1977) strongly argued that the personal taxes fully eliminate the tax advantage of debt and therefore there is no optimal capital structure. The conclusion that the company should stop worrying about its capital structure appears to support the first capital structure theory from Modigliani and Miller.

The purpose of this article is to critically evaluate the statement that “as a result of the elimination of the tax advantage of debt in a world with personal and corporate taxes, the firms should stop worrying about finding the optimal debt or equity mix to finance their businesses leading to the acceptance of Miller and Modigliani propositions.” This article is structured as follows. First, it will slightly describe the tax benefits of debt. Second, it will briefly explain the Modigliani and Miller propositions. Third, it will evaluate the concept being discussed in this article. The final part will be the conclusion.

2.   Corporate and Personal Taxes, Modigliani and Miller Propositions, and Optimal Capital Structure

The tax benefits of debt have important role in the corporate financing decisions, because the debt financing has one significant advantage under the corporate income tax system (Graham, 2000). The advantage is “the interest (of debt) that the company pays is a tax-deductible expense” (Brealey, Myers & Allen, 2008: p.497). Furthermore, Lumby and Jones (1999) explain that the total after-tax cash flow of the company will rise as it increases its gearing. In other words, the more a company uses debt to finance its capital, the more interest of debt that the company should pay, and hence the amount of tax that the company should pay is smaller. Therefore, it is clear that the company should take into account the taxes when finding the optimal capital structure and use this advantage as an important consideration.

In 1958, Modigliani and Miller introduced the capital structure theory, which explains that the value of a company is independent of its capital structure, based on some assumptions such as no corporate and personal taxes, no transaction cost, perfect market conditions, and symmetric information. In 1963, Modigliani and Miller finally considered the existence of corporate taxes and built new propositions. The proposition with taxes of Modigliani and Miller theory states that the value of a levered firm is equal to the value of an unlevered firm plus the present value of the interest tax shield. The value of a firm increases as the total debt increases because of the interest tax shield. However, it is illogical if it reaches the conclusion that the optimal capital structure is one hundred percent of debt (Ross et al, 2006). Moreover, Miller (1977) strongly states that the value of the company will still be independent of its capital structure, even in a world in which the interest payment is fully deductible in computing corporate finance. It is because there is a weight cost attaching to the use of debt financing such as bankruptcy cost.

The capital structure analysis from MM theory implies that in a taxed world the tax relief on debt interest would encourage a company to use debt financing as high as possible. However, Modigliani and Miller only considered corporate taxes without concerning the personal taxes (Lumby & Jones, 1999). The presence of personal taxes changes the importance of tax advantage of debt.  Miller’s (1977) analysis suggests that when the personal taxes are taken into account, the value of the tax shield on corporate debt interest reduces to zero. It implies that there is no advantage if a company uses debt to finance its capital structure. Therefore, the existence of optimal capital structure is irrelevant.

In the light of above it is clear that the existence of optimal capital structure is still being debated. This article emphasizes that the optimal capital structure still exists based on some important arguments, criticisms and evaluations.

First of all, in contrast to Miller’s argument (1977), it is believed that the presence of personal taxes does not fully eliminate the tax advantages of debt. It is supported by the research from Graham (1999), which the result of his research against Miller’s conclusion. He argues that the personal tax penalty reduces, but does not eliminate, the tax incentive to use debt. The research from Green and Hollifield (2003) also found that in their research model, the tax advantages of equity at the personal level are not sufficient to completely offset the tax advantages of debt.  It implies that the company could obtain the tax advantage of debt, although the benefit would not be as big as before the personal taxes are introduced. Graham (1998) also contributes that adjusting for personal taxes is statistically important. Therefore, the point is the personal taxes must be taken into consideration along with corporate taxes, when a company finding an optimal capital structure. According to Brealy et al (2008:p.501), they explain, “the firms should try to minimize the present value of all taxes paid (include personal and corporate taxes) on corporate income.” Moreover, they argue that the firm’s objective is to arrange the capital structure in order to maximize after-tax income. The important matter that could be achieved is that the presence of personal and corporate taxes does not remove the importance of capital structure. The optimal capital structure clearly could be calculated. Therefore, it is certain that the optimal capital structure still plays important role in the financing decisions.

Second, if the company stop considering about the optimal capital structure, then the objective of its company to maximize the shareholders wealth is difficult to be achieved. An optimal capital structure is very important for every company, in order to find the optimal mixing of debt and equity to finance its capital, and therefore the shareholders could obtain after tax income as high as possible. The personal and corporate taxes are not the obstacles, which make the optimal capital structure is unimportant. According to DeAngelo and Masulis (1980:p27), they state “each firm has a unique interior optimum leverage decision due solely to the interaction of personal and corporate tax treatment of debt and equity.” This research finding makes clear that the optimal capital structure is relevant. Therefore, the optimal capital structure is still an important matter for every company.

             In addition, the theory from Modigliani and Miller (1958) proved that financing decision for a company does not matter. They argue that the choice between debt and equity to finance the capital structure of a company has no effects on the value of its company. However, according to Myers (2001), it is strongly stated that financing decision clearly can matter. He explained three reasons about why the capital structure is an important matter. The reasons are the existence of taxes and the possible of financial distress, the differences in information, and the existence of agency cost. There are three capital structure theories that have been developed in which differ in their relative emphases on these factors. The trade off theory emphasizes taxes and financial distress, the pecking order theory emphasizes differences in information, and the free cash flow theory emphasizes agency costs (Myers, 2001). This article point out that in his research the presence of taxes is the reason leading to the importance of an optimal capital structure. Hence, it is clear that the presence of corporate and personal taxes does not eliminate the existence of an optimal capital structure.

Third, the optimal capital structure is an important matter that could not be ignored by the companies. Givoly, Hayn, Ofer and Sarig (1992) prove that there is a positive relation between changes in US corporate taxes and changes in leverage. They also find that both corporate and personal taxes affect leverage decisions. It is also supported by the research from Graham (2003) in which the result of his research is that taxes affect corporate financial decisions. Moreover, he also points out that there is cross-sectional regression evidence that high tax rate firms use debt more intensively than do low tax rate firms. Surprisingly the result of the previous research from Graham (2000) also proved that there is a trend in which indicates that the companies use debt more aggressively now than they did in the 1980s. Furthermore, Graham and Harvey (2001) interview 392 CFOs in the United States, and they find that the tax advantage of interest deductibility is of significant concern by CFOs in large, regulated, and dividend-paying firms. All of these empirical and previous studies imply that the optimal capital structure does exist and the company should consider about the corporate and personal taxes when mixing the debt and equity financing.

3.   Conclusion

In conclusion, this article argues that it is not true that the companies do not need to consider about the capital structure. The optimal capital structure does exist based on some important reasons and arguments. First, the presence of personal taxes does not fully eliminate the tax benefit of debt (Graham, 1998; Green & Hollified, 2003). The personal and corporate taxes should be considered in finding the optimal capital structure. Second, every company has a unique interior optimum leverage decisions (DeAngelo & Masullis, 1980). Thus, it is important for the company to consider about the optimal capital structure as it helps to actualize the purpose of the company in maximizing shareholders wealth. Third, many empirical studies support the existence of capital structure. According to Givoly et al (1992), they found that the personal and corporate taxes affect leverage decisions. Futhermore, Graham (2000) found that the companies use debt more aggressively now rather than in 1980s. The presence of personal taxes does not eliminate the tax benefits of debt, in turn; it could be used along with corporate taxes as important consideration to find the optimal capital structure. Therefore, the optimal capital structure is a significant matter that very important to be considered by the company.

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