Capital Structure Assignment Example | Topics and Well Written Essays - 2500 words

Capital Structure - Assignment Example Perhaps the value of the firm does depend on how its assets, cash flows and growth opportunities are sliced up and offered to investors as debt and equity claims. There are surely investors who would be willing to pay extra for particular types or mixes of corporate securities. For example, investors cannot easily borrow with limited liability, but corporations provide limited liability and can borrow on their stockholders' behalf. There has been constant innovation in the design of securities and in new financing schemes. Innovation proves that financing can matter. If new securities or financing tactics never added value, then there would be no incentive to innovate (Myers 2001). Modigliani and Miller's (1958) theory is exceptionally difficult to test directly, but financial innovation provides convincing circumstantial evidence. The costs of designing and creating new securities and financing schemes are low, and the costs of imitation are trivial. (Fortunately, securities and financing tactics cannot be patented.) Thus temporary departures from Modigliani and Miller's predicted equilibrium create opportunities for financial innovation, but successful innovations quickly become "commodities," that is, standard, low-margin financial products. The rapid response of supply to an innovative financial product restores the Modigliani and Miller equilibrium. ... The Miller theory will be referred again in later parts of this paper. Corporate Taxation In 1977, Merton Miller revisited the issue of the impact of corporate taxation on the irrelevance propositions in a classic paper titled "Debt and Taxes" that shows perhaps better than any of his other papers how he could use arbitrage arguments to change how finance academics and practitioners understood how the world works (Miller 1977). In that paper, he pointed out that the tax advantage of corporate debt might be mostly if not completely illusory. Because interest on corporate debt is taxed as income for the holder of corporate debt, the interest paid on corporate debt must be high enough so that the after-tax income from holding corporate bonds is attractive relative to the income from equity which, when it accrues as capital gains, is taxed at a lower effective rate (Myers 2001). As a result, corporations get to deduct from their taxes interest payments but, because personal taxes on interest income are higher than on capital gains, the before-tax cost of capital on debt must be higher than on equity if investors are to hold debt (Stulz 2000). Interest is a tax-deductible expense. A taxpaying firm that pays an extra pound of interest receives a partially offsetting "interest tax shield" in the form of lower taxes paid. Financing with debt instead of equity increases the total after-tax dollar return to debt and equity investors, and should increase firm value (Myers 2001). Application of Taxation This present value of interest tax shields could be a very big number. Suppose debt is fixed and permanent, as Modigliani and Miller (1963) assumed, and that corporate income is taxed at the current 35 percent statutory rate.