Question

Faulkender and Smith (2016) find firms operating in countries with higher tax rates tend to use more debt. In years when tax rates are lower, firms are found to decrease leverage levels. Furthermore, they show firms in all countries borrow less than their full borrowing capacity.

Requirement: Critically comment on these findings in relation to Modigliani–Miller (M&M) theory (with tax) by answering the following tow questions. .

a) In what respect the above findings are consistent with the prediction of M&M (with tax) theory?

b) In what respect the findings are not consistent with the predication of M&M theory (with tax) and what could be the reason(s)?

Please type your answers in the box below.

Reference: Faulkender, M., & Smith, J. M. (2016). Taxes and leverage at multinational corporations. Journal of Financial Economics, 122(1), 1-20.

Answer 1

a)

The MM view with tax

In 1963 M&M modified their model to include the impact of tax. Debt in this circumstance has the added advantage of being paid out pre-tax. The effective cost of debt will be lower as a result.

Implications : As the level of gearing rises the overall WACC falls. The company benefits from having the highest level of debt possible.

As debt became even cheaper (due to the tax relief on interest payments), cost of debt falls significantly from Kd to Kd(1-t). Thus, the decrease in the WACC (due to the even cheaper debt) is now greater than the increase in the WACC (due to the increase in the financial risk/Keg). Thus, WACC falls as gearing increases. Therefore, if a company wishes to reduce its WACC.

Benefits of cheaper debt > Increase in Keg due to increasing financial risk.

Companies should therefore borrow as much as possible. Optimal capital structure is 99.99% debt finance.

b)

There is clearly a problem with Modigliani and Miller’s with-tax model, because companies’ capital structures are not almost entirely made up of debt. Companies are discouraged from following this recommended approach because of the existence of factors like bankruptcy costs, agency costs and tax exhaustion. All factors which Modigliani and Miller failed to take in account.

• It doesn't consider Tax exhaustion point: Only get tax exemption if there is taxable profit
• It doesn't consider bankruptcy risk: In the initial stage there is no bankruptcy but at the later stages there is no bankruptcy will increase. So there is a chance of increase the WACC.
• Agency costs: Agency costs arise out of what is known as the ‘principal-agent’ problem. In most large companies, the finance providers (principals) are not able to actively manage the company. They employ ‘agents’ (managers) and it is possible for these agents to act in ways which are not always in the best interest of the equity or debt-holders.