Tax Effect on a Corporate's Financial Policy

Financial policy is the criteria describing a corporation's choices regarding its debt/equity mix, currencies of denomination*, maturity structure*, method of financing investment projects, and hedging decisions with a goal of maximizing the value of the firm to some set of stockholders.

The Modigliani-Miller Theorem comprises four distinct results from a series of papers (1958, 1961, 1963). The first proposition establishes that under certain conditions, a firm’s debt-equity ratio does not affect its market value. The second proposition establishes that a firm’s leverage has no effect on its weighted average cost of capital (i.e., the cost of equity capital is a linear function of the debt-equity ratio). The third proposition establishes that firm market value is independent of its dividend policy. The fourth proposition establishes that equity-holders are indifferent about the firm’s financial policy.

Miller and Modigliani (1963) and Miller (1977) showed that under some conditions, the optimal capital structure can be complete debt finance due to the preferential treatment of debt relative to equity in a tax code. For example, in the U.S. interest payments on debt are excluded from corporate taxes. As a consequence, substituting debt for equity generates a surplus by reducing firm tax payments to the government. Firms can then pass this surplus on to investors in the form of higher returns. This raised the further provocative question – were firms that issued equity leaving stockholder money on the table in the form of unnecessary corporate income tax payments? Miller (1977) resolved this problem by showing that a firm could generate higher after-tax income by increasing the debt-equity ratio, and this additional income would result in a higher payout to stockholders and bondholders, but the value of the firm need not increase. The crux of the argument is that as debt is substituted for equity, the proportion of firm payouts in the form of interest on debt rises relative to payouts in the form of dividends and capital gains on equity. Higher taxes on interest payments than on equity returns reduce or eliminate the advantage of debt finance to the firm.

As a common conception, debt has tax advantages at the corporate level because interest payments reduce the firm’s taxable income while dividends and share repurchases do not.  Unless personal taxes negate this advantage, interest ‘tax shields’ give corporations – that is, shareholders – a powerful incentive to increase leverage.

The trade-off theory of capital structure is largely built upon the tax benefits of debt. In its simplest form, trade-off theory says that firms balance the tax benefits of debt against the costs of financial distress. (Leverage might also affect agency conflicts among stockholders, bondholders, and managers.) Tax effects dominate at low leverage, while distress costs dominate at high leverage. The firm has an optimal, or target, debt ratio at which the incremental value of tax shields from a small change in leverage exactly offsets the incremental distress costs.

*Denomination is a proper description of a currency amount, usually for coins or banknotes.

*Maturity Structure is the profile and length of time to the redemption and repayment of a company's various debts.