Question

Based on the MM theory, explain how capital structure is influenced by taxes. Would the result be different if considering bankruptcy costs? Illustrate.

Answer 1

The Miller-Modigliani theory holds that the capital structure is influenced by the taxes and the bankruptcy costs. This is because the tax treatment is different for debt and equity.

When there are no corporate or personal taxes, the firm's cost of equity capital is a linear function of the firm's capital structure. In other words, the effect is only dependent on the total capital irrespective of what proportion is of equity or debt.

In a situation, where taxes are introduced, the difference arises due to the difference in tax treatment. Interest on debt is tax-deductible. This gives rise to a tax shield. Due to this, the value of the firm, in this case, increases by the present value of the tax shield. To gain advantage from the tax shield, if a firm increases its debt, the cost of equity rises, however, the total WACC comes down. This is because as debt in the capital structure is increased, the riskiness of the firm increases and equity shareholders demand a higher rate of return. The value of the firm after taxes is effectively increased by the present value of tax shield.

Yes, the result would be different when bankruptcy costs are considered. The value of the firm starts to decrease as the bankruptcy costs increase. The value of the firm with bankruptcy costs are reduced by the present value of bankruptcy and distress costs.