Before , academic discussion in finance was focused on : WHAT MARKET REALLY CAPITALIZED

through DIV, PAT , OP or weighted combination of these?

1958

Application of tools of economics or economist’s model and assumptions

Discriminating monopsony == optimal capital

structure of firmEconomist’s

assumption are rational behavior,

perfect market

In equilibrium, the market value of any firm must be independent of its capital structure.

Arbitrage proof , can be found …

Interest payments can be deducted from taxable corporate income

The value of firm can be increased by the use of debt but stakeholders must incur increasing risks of bankruptcy and the costs, direct and indirect, of falling into that

unhappy state.

Balancing of these bankruptcy costs against the tax gains of debt finance gives rise to an optimal capital structure .

In this paper, Miller has argued that even in a world in which interest payments are fully deductible in computing corporate income taxes, the value of firm, in

equilibrium will still be independent of its capital structure.

The 5 parts of the paper

1.Bankruptcy costs in perspective. (Tradeoff between bankruptcy and tax shield is complex issue)2.Taxes and capital structure: the empirical record (tax rate increased but debt ratio constant)3.The tax advantages of debt financing reexamined ( personal income tax along with corporate tax is considered, for mathematical representation)4.Taxes and market equilibrium ( Explanation of 1 & 2 through figure)5.Market equilibrium and the behavior of firms and individuals. ( )

Bankruptcy = deadweight cost

Bankruptcy cost = 20% of the value of the estate and according to E . Han Kim this cost may eat up no less than 40% of the firms assets.

Tax rate was 10 or 11 % in 1920 and 52% in 1950

In this period the tax rate has little relation with debt ratio and substitution of debt for preferred stock !!!In this period the debt ratio was changed due to :

• Cyclical movement of economy• Expansion through equity due to stock market rise

POST 1950 !!

For wide ranges of values the gain from leverage vanishes entirely or even turns negative

•If all tax rate=0•If personal tax for stock= personal tax for bond•If personal tax for stock< personal tax for bond ( Bond return should be very high)• If

Need equilibrium !!!

Explanation

ASSUMPTIONSPersonal tax rate on income from stock =0Bonds are• riskless• no transaction cost•No floating costs• surveillance costs

1. Marginal rate of personal income tax on interest income is increasing, Demand rate of interest is upward

2. Upper part of SRI = higher chance of default3. DRI at y-axis = fully tax exempt bond and then fully taxable bond by fully tax-

exempt individuals and organizations. Next, taxable investors participation with higher need of interest

Not end but the start of researching…

THANKS