File:L12BMMTax

L12B-MM Theory of Capital Gearing with Corporate Taxes

MM used arguments similar to those discussed earlier to examine the impact of corporate
taxes. They found that debt provides a benefit to the firm because of the tax deductibility
of interest payments. The implication of their analysis in this case is that the value of the
firm is maximized when its capital structure contains only debt. Although this extreme
result is impractical because of limited access to capital markets and borrowings in reality,
the inference is that firms should use as much debt as they possibly can.
The results of the MM analysis can be summarized as follows :
A.

The only benefit of debt financing (relative to equity financing) is the reduction in
corporate income taxes due to the tax deductibility of debt interest.

B.

There is no disadvantage of debt financing relative to equity financing.

Implications for Financing. If a firm is not paying corporate income taxes, the financing
decision is irrelevant. It doesn't matter one way or the other whether or not debt is used.
A firm paying corporate taxes should maximize its use of debt. Debt is superior to any
other financing source.
CRITICISMS OF THE MM ANALYSIS
There are four conditions that must be met in order to validate the MM analysis and
produce the above results:
1.

No costs are imposed on the firm when it defaults on debt payments or goes
bankrupt.

2.

Investors must be able to do their own borrowing, using "home-made leverae", if

they desire higher returns (with higher risk) than the returns provided by debt free
or low-debt firms.

3.

Investors must be able to undo the leverage achieved by a corporation by

purchasing a proportionate share of all the outstanding claims against corporate
income.

4.

Personal taxes must be neutral with respect to the choice between debt and equity.

Critics of the MM position have focused their attack on the realism of assuming these four
conditions. We can separate these criticisms into two groups. The first group of criticisms
is directed toward result A, that the only benefit from debt financing is due to the tax
deductibility of interest. The second group of criticisms is directed toward point B, that
there is no disadvantage to debt even if used very heavily. We summarize the various
arguments below.
Arguments Supporting Additional Benefits from Debt
1.

The risk of leverage as perceived by an individual investor borrowing money is

different from the investor's perception of the risk of leverage when the corporation
borrows the money. Corporate leverage and homemade leverage are not perfect
substitutes from the standpoint of the person doing the borrowing. Therefore,
individuals will prefer that the corporation rather than they do the borrowing. One
reason for this difference is risk in the limited liability of a corporate stockholder. If
the corporation borrows and goes bankrupt, individuals lose at most their
investment. If the individual borrows to finance stock purchases and the stock
becomes worthless, the creditors can take over assets owned by the individual to
pay off the debt.

2.

The interest rate charged by lenders may be greater for an individual than for a
corporation. Therefore, it will be cheaper from the viewpoint of the stockholders to
have the corporation do the borrowing.

3.

There are legal limitations inhibiting homemade leverage. Mutual funds and trust
funds that invest heavily in common stock cannot borrow, and so these investors
may prefer corporations with debt.

Arguments Implying a Disadvantage to Debt

1.

The firm is likely to incur costs and suffer penalties if it does not meet its promised
principal and interest payments. Legal expenses, disruption of operations, and loss
of potentially profitable investment opportunities may result. As the amount of
debt in the capital structure increases, so does the probability of incurring these
costs. Consequently there are disadvantages to debt, and excessive use of debt may
reduce the value of the firm. This is one of the most telling arguments against result
B above.

2.

Investors seeking to undo excessive leverage will incur transaction costs (brokerage
fees from buying and selling securities) that would otherwise not need to be paid.
Therefore the securities of highly levered firms will sell at somewhat lower prices
that MM would predict.

3.

Much corporate debt is not marketable. It consists of loans made by banks and
other financial institutions. Therefore, investors cannot undo excessive leverage
because they cannot purchase a proportionate share of the outstanding claims
(stock and debt) against the firm's income.

4.

Many institutional investors such as banks and life insurance companies cannot
legally purchase low-rated bonds such as those issued by a highly levered
corporation. Therefore the interest rates on highly rated, "investment grade" bonds
are significantly lower than those on more risky bonds.

5.

As firms in general increase their use of debt financing, they provide increasing
amounts of interest which is taxed as ordinary income at the expense of capital
gains on the stock which is taxed at lower effective rates.

6.

The existence of risky borrowing by the firm (risky in the sense that the firm might
not be able to repay the debt) can cause the firm to adopt a less profitable
investment strategy than it would if it had no risky debt outstanding.