DEBT AND TAXES*

Abstract

The somewhat heterodox views about debt and taxes that will be presented here have evolved over the last few years in the course of countless discussions with several of my present and former colleagues in the Finance group at Chicago—Fischer Black, Robert Hamada, Roger Ibbotson, Myron Scholes and especially Eugene Fama. Charles Upton and Joseph Williams have also been particularly helpful to me recently in clarifying the main issues.11 More than perfunctory thanks are also due to the many others who commented, sometimes with considerable heat, on the earlier versions of this talk: Ray Ball, Marshall Blume, George Foster, Nicholas Gonedes, David Green, E. Han Kim, Robert Krainer, Katherine Miller, Charles Nelson, Hans Stoll, Jerold Warner, William Wecker, Roman Weil, and J. Fred Weston. I am especially indebted (no pun intended) to Fischer Black. My long-time friend and collaborator, Franco Modigliani, is absolved from any blame for the views to follow not because I think he would reject them, but because he has been absorbed in preparing his Presidential Address to the American Economic Association at this same Convention. This coincidence neatly symbolizes the contribution we tried to make in our first joint paper of nearly twenty years ago; namely to bring to bear on problems of corporate finance some of the standard tools of economics, especially the analysis of competitive market equilibrium. Prior to that time, the academic discussion in finance was focused primarily on the empirical issue of what the market really capitalized.22 To avoid reopening old wounds, no names will be mentioned here. References can be supplied on request, however. Did the market capitalize a firm's dividends or its earnings or some weighted combination of the two? Did it capitalize net earnings or net operating earnings or something in between? The answers to these questions and to related questions about the behavior of interest rates were supposed to provide a basis for choosing an optimal capital structure for the firm in a framework analogous to the economist's model of discriminating monopsony. We came at the problem from the other direction by first trying to establish the propositions about valuation implied by the economist's basic working assumptions of rational behavior and perfect markets. And we were able to prove that when the full range of opportunities available to firms and investors under such conditions are taken into account, the following simple principle would apply: in equilibrium, the market value of any firm must be independent of its capital structure. The arbitrage proof of this proposition can now be found in virtually every textbook in finance, followed almost invariably, however, by a warning to the student against taking it seriously. Some dismiss it with the statement that firms and investors can't or don't behave that way. I'll return to that complaint later in this talk. Others object that the invariance proposition was derived for a world with no taxes, and that world, alas, is not ours. In our world, they point out, the value of the firm can be increased by the use of debt since interest payments can be deducted from taxable corporate income. To reap more of these gains, however, the stockholders must incur increasing risks of bankruptcy and the costs, direct and indirect, of falling into that unhappy state. They conclude that the balancing of these bankruptcy costs against the tax gains of debt finance gives rise to an optimal capital structure, just as the traditional view has always maintained, though for somewhat different reasons. It is this new and currently fashionable version of the optimal capital structure that I propose to challenge here. I will argue that even in a world in which interest payments are fully deductible in computing corporate income taxes, the value of the firm, in equilibrium will still be independent of its capital structure. Let me first explain where I think the new optimum capital structure model goes wrong. It is not that I believe there to be no deadweight costs attaching to the use of debt finance. Bankruptcy costs and agency costs do indeed exist as was dutifully noted at several points in the original 1958 article 28, [see especially footnote 18 and p. 293]. It is just that these costs, by any sensible reckoning, seem disproportionately small relative to the tax savings they are supposedly balancing. The tax savings, after all, are conventionally taken as being on the order of 50 cents for each dollar of permanent debt issued.33 See, among others, Modigliani and Miller 27. The 50 percent figure—actually 48 percent under present Federal law plus some additional state income taxes for most firms—is an upper bound that assumes the firm always has enough income to utilize the tax shield on the interest. For reestimates of the tax savings under other assumptions with respect to availability of offsets and to length of borrowing, see Kim 21 and Brennan and Schwartz 12. The estimate of the tax saving has been further complicated since 1962 by the Investment Tax Credit and especially by the limitation of the credit to fifty percent of the firm's tax liability. Some fuzziness about the size of the tax savings also arises in the case of multinational corporations. The figure one usually hears as an estimate of bankruptcy costs is 20 percent of the value of the estate; and if this were the true order of magnitude for such costs, they would have to be taken very seriously indeed as a possible counterweight. But when that figure is traced back to its source in the paper by Baxter 5 (and the subsequent and seemingly confirmatory studies of Stanley and Girth 36 and Van Horne 39), it turns out to refer mainly to the bankruptcies of individuals, with a sprinkling of small businesses, mostly proprietorships and typically undergoing liquidation rather than reorganization. The only study I know that deals with the costs of bankruptcy and reorganization for large, publicy-held corporations is that of Jerold Warner 40. Warner tabulated the direct costs of bankruptcy and reorganization for a sample of 11 railroads that filed petitions in bankruptcy under Section 77 of the Bankruptcy Act between 1930 and 1955. He found that the eventual cumulated direct costs of bankruptcy—and keep in mind that most of these railroads were in bankruptcy and running up these expenses for over 10 years!—averaged 5.3 percent of the market value of the firm's securities as of the end of the month in which the railroad filed the petition. There was a strong inverse size effect, moreover. For the largest road, the costs were 1.7 percent. And remember that these are the ex post, upper-bound cost ratios, whereas, of course, the expected costs of bankruptcy are the relevant ones when the firm's capital structure decisions are being made. On that score, Warner finds, for example, that the direct costs of bankruptcy averaged only about 1 percent of the value of the firm 7 years before the petition was filed; and when he makes a reasonable allowance for the probability of bankruptcy actually occurring, he comes up with an estimate of the expected cost of bankruptcy that is, of course, much smaller yet. only the direct costs of reorganization in The deadweight costs of if were available of the costs, such as the of the and of from of or the of and to into For more on this see and But about the size of these we can that if the direct and deadweight costs of the to up of the tax savings, other of debt with deadweight costs would be in a somewhat but is by also that the discussion has to costs much the same to the costs in the as in the costs of and 20 or the of of Black, Miller and case in point is the income payments on such be in any only if and if and are fully deductible in computing corporate income But if not and not in any the have no to The interest payments typically for a of to are to the in are securities that to have the supposed tax of the bankruptcy cost because to or the at a a firm have but no for a in the such are The this to the that such 27. They were in the course of the railroad bankruptcies in the and they are to be still with that in the of an it to have the of about But the is that of Roman has no the were as as the analysis of the tax to debt to or tax would since have found to to income In the on bankruptcy costs in discussions of optimal capital structure to me to have been For businesses, at (and particularly for such ones as or the supposed between tax gains and bankruptcy costs the for the and one In this it is to that the optimal debt to value in the presented in the paper by E. Han Kim 21 turns out to be percent very than the debt for the even though assumes that bankruptcy costs would up no than percent of the firm's in the of also on the other of the the optimal capital structure were a of balancing tax against bankruptcy costs, have capital over related is there to be no between debt and corporate tax rates in the of the Economic and I into the in under the of the on and Credit I among other that the of the in the was different from that of the the that tax rates 10 and 11 percent in the to percent in the The of corporate debt in the of in tax rates was noted by many other in this See, and the there rise as to be mainly a of debt for rather than of debt for The in debt primarily the of the debt to because the of dividends earnings up and because the of to debt in new to rise when the market was My study for the the only the of the of of available for the years that some in debt to be taking in the at in Some of this however, is a of the of in the of that taxable earnings an in will to earnings (and the that would have been in the same direction were the for rather than for and On the other debt would to be by the the of debt such as and liability. considerable further direct of and debt to of earlier is no But we were to make the that the rise in debt decisions rather than in that would still have that the its of debt from about to only about of the For Federal that debt the from percent of to percent. debt from about 7 percent to percent of over the same The for the end of were percent for debt and percent for The here and refer of course, to debt for the of debt securities that are by and other corporations. have been the case in the the was in the that corporate debt were and This was a after all, in which an and very issue to the back however, with the of the in debt of such in can be to be a to a of rather than a permanent in corporate capital For an independent of these that is in most see in was taking as firms to against by or or of this was by combination that to a in such of as and especially of the return on the was up in earnings and since will the of earnings to interest payments even with no in the interest in But this after the issue of the one more of that by the in an the is In the have been have been and of corporate have been to something to have been to market as always in the when the market was when the for the first of the are we are to be the same we in the debt only than of the tax The discussion in the has focused mainly on at in the that value to corporate capital structure than would market value of which are to in the of of the end of by in The and for a of debt to market value for corporations of percent. even this is a on the since the debt is at value and not the in the value of debt in the of the In at the of the the debt at market value was only about percent. The in years was percent at the end of after a of in the market value of and the is now than it was In the it was still possible to the that the of corporations to reap the tax of debt be a in corporate finance and the tax savings they would to debt on the of any others in the still in a state of from the But can no be expected from that that has years and no of is for any to There are few that firms were to the by as direct as of debt for was able to only about such corporations in the and of these were an after the in the market in and some of in more to be to than to the capital structure. And since to the be to the bankruptcy costs or agency costs of debt there would seem to be only one to the tax of debt must be than the The of the in the paper was one of agency costs in that the costs of debt such debt as a market the in this direction was but only in the original 1958 I the Presidential of being to from my earlier we there in the It also be out that our tax in other to the gains from debt on debt in the capital structure, for example, a to out a of its income in the of interest payments taxable to the under the income debt by can in the of its net income and to this the only to the capital gains to no tax at by of the at We to the same of in the paper in In that the in the was on what be a were to to of as not to be to when they believe to be are by no with the to be here. The point was in a more and by and were by and in by Fischer still but were to sometimes in very in the course of many and that when tax rates are to the indeed to the standard of And when the income tax on income from is the same as that on income from case of of course, is when there is to be no income tax at the from is the But when the tax on income from is than the tax on income from the from will be than In for a range of for and the from or even turns Let me that this is no due to The or turns into a because investors securities for the they and will in of net of tax the tax on income from is than that on income from the return on taxable has to be other to this tax no taxable would to it is still true that the of a have the of interest payments to in computing corporate income these interest payments have been to by any in the taxes that the will have to on interest income. The of at the one to the of at the analogous in the of the is in Miller and Upton of this has also been to explain the of among many others, Miller p. The that percent of any dividends by a taxable can be in computing its taxable the on and offsets the of the rates to the 1 1 1 the is and the of the reap no from use of debt rather than But we can more than in which the of corporations by debt for would be with market equilibrium. to these opportunities would in a world with income taxes, to in the on and and in in the equilibrium and the to issue more even bankruptcy costs or costs as a ex many other propositions in is think of Let me the a however, by a simple that will I to the that the equilibrium about and to some of the of that equilibrium. for that the tax on income from were (and see later that this be a than it And for of that are and that there are no costs, costs or costs in in such a world, the equilibrium of the market for would be that in The of is the and the of interest the The for by the is by the it is a even though it is at the equilibrium of interest on fully as of state and The of the to the the for fully taxable corporate by fully and these investors would be the of corporate if the market interest on corporate were only taxable who to in his or would it to To these taxable investors into the market for corporate the of interest on such has to be enough to for the taxes on interest income under the income More for an of income tax on interest income is the of on taxable corporate would be the on tax up by the tax 1 1 the income tax is the interest has to keep to in investors in and tax the in the for The of this with the the point 1 the up by the corporate tax the market equilibrium. corporations were to a of than interest rates would be 1 and some firms would to be a the were interest rates would be than 1 and some firms would it to to The market equilibrium by the of the will have the following There will be an equilibrium of corporate and an for the corporate as a But there would be no optimum debt for any following a or or would a market among investors in the tax for a the would the for securities at the other end of the But one is as as the And in this it would still be true that the value of any firm, in equilibrium, would be independent of its capital structure, the of interest payments in computing corporate income The of corporate and valuation at the implied by this model are in but further analysis is to of is that it makes it to see the to the following the stockholders of corporations don't reap the of the tax gains from who of finance, of only and only after in colleagues in other 1 and other tax as as in tax and from what be a interest rates have to be up to the taxes of the tax in equilibrium will be to the corporate In point of the between and has typically been of the corporate though are because of in of course, the that the tax of will be and of a different also be that The study of the of securities by gives of the tax of of such that are but usually somewhat the corporate that this can however. (and have to the corporate in effect, when they to equilibrium of the in 1 not of course, that the tax on income from of the be but only that it be than his or on income from a however, the that the at the is to not be of the in mind that a is also at in the market for The will be by tax and income more of return in the of capital gains will to the in the upper The presented in the study of by Blume, and p. are with this of effect, though its magnitude is somewhat smaller than have been expected a They for example, that in the of dividends to the market value of was about percent for investors with income of than as to percent for with of or this effect, an analogous to that in 1 can be to that the value of a firm be to its the more tax of capital gains than of Some in that direction were in the paper more analysis was by and Scholes For a related model with tax on see The tax on such gains is than in But no taxes on gains and only a small of gains in and in any and on capital gains can not only be at the of the remember that by 10 years of tax is almost as as the Tax Act of be if thanks to the of the tax basis to his or To the that the tax on income from is than the the equilibrium interest will be that in In the case where the tax or to income from were or small that 1 1 implied a value for than the of the income no market equilibrium would be would indeed be a from the point of as the standard model of the tax to exist only by of it that not be with or with other of such as The analysis 1 can be to for borrowing, but there are makes is not a of For the in these it to that in the equilibrium of the capital of course, to be For a discussion of some of the of corporate taxes the of interest payments under conditions of see can be in 1 by the interest rates as or The is, that of in will in the stockholders full tax shield Kim 21 and Brennan and Schwartz the firm has against which its can be or it can the of the and the corporate on a taxable firm, some of the interest goes to To firms to issue the would have to be than 1 1 and the more the the of however, do not the of for of the recently by and earlier by were to from the of the market and especially from the strong of the for In of any such in the for securities would up in the first as a value for a value for the equilibrium corporate 1 the 1958 article 28, also discussion of paper will be by the bankruptcy costs And this will among other that the full of the bankruptcy costs or costs is not by the as is of the costs are to the in the of rates of interest in equilibrium. model of the in 1 in up most of the and in I and between the tax gains of debt and the costs of bankruptcy particularly for the of market interest in income and especially the of the corporate debt to rise in to the in tax rates since the these in rates in the as as subsequent and have the corporate and in the same The model also as for other of the of corporate finance such as the of the market from an to an market in the and For an of that that the of tax that see On the other many questions still to be about in debt ratios, for on which has been of the few studies of in debt is that of Schwartz and but it really more than the that and railroads have debt than firms in and they be by the market equilibrium model presented here or some of do the some of the that the of market about the of and among out in of tax as as the for the tax and the main of the other such as agency The for more the end of a Presidential and it is a that I know will to see Let me by trying to as I in the to the of complaint against market equilibrium analysis of of the here firms and investors don't behave that the behave that is taken to that firms and don't the that the in it is most corporate or that I have or be expected to enough about the course of for a firm's securities to even a academic that the firm's value indeed been by some or the of the are and even as with much of what for capital they the of On this score, has there been any that the (and the of and his a more of the really and out on the than any of the that any do keep trying to that rational behavior by They are I to into they are working on problems of they have found from only in finance, but the the rational behavior to and at the of the the market and the than any available to at no with the of they actually in It rather that are at to value to that are with rational market equilibrium, from rational they to be when up and in a for the of the to been as in virtually every textbook in finance and over the last But we must be of the that because a it must have some value must have a rational The and related invariance for example, are on that corporate finance would not much over decisions that really The however, that we can about the market equilibrium is that in will that no but do no can in in the can the in we be in simple of corporate finance can of such My is the finance See, the discussion in To that even are is not to however, that is just a or the to are or a that is in one value if the The of and the to the new conditions to more and more than if a new and original of were these and of in the are and the between the and of our Association be to be and than the sometimes of the last 20 years seem to