Taxation Thought Experiment

[Igor Chudov @ home]

Dr.Dimitri Vulis KOTM wrote:
> ichudov at algebra.com (Igor "FUCK MNE HARDER" Chudov @ home) writes:
> > Dr.Dimitri Vulis KOTM wrote:
> > > Therefore it's sometimes more profitable for a company to raise money by
> > > issuing bonds (debt) and paying tax-deducuble interest than by selling its
> > > stock (equity) and paying non-decuctible dividentds to stockholders.
> > There is, in fact, a neat theorem that says that (*_under certain
> > assumptions_*) the value of a firm does not depend on its capital
> > structure.
> 
> Igor, you begin to sound just like Timmy May - talking about things you know
> nothing about. 

Surely I know nothing about finance. Never claimed otherwise.

> Yes, there's a famous theorem by Franco Modigliani and Merton
> Miller, the Nobel prize winners which says that ABSENT TAXES, the value of the
> firm doesn't depend on its debt-to-equity ratio. M&M also show that under U.S.
> tax laws the best capital structure is 100% debt (again, ignoring other
> available deductions, such as depreciation, and increased risk and cost of
> borrowing as the debt increases).

See below.
 
> "The value of the levered firm is the value of the levered firm plus the
> interest tax shield (the amount of debt times the tax rate)."
> 
> Companies would borrow less (and people would take out mortgages on their
> residences less) if the interest payments weren't tax-deductible.

See, for example, Merton H. Miller, "Debt and Taxes", American Finance
Assn., Vol. XXXII, May 1977, No. 2. 

Page 262: ``... They conclude that the balancing of these bankruptcy costs
against the tax gains of debt finance gives rise to an optimal capital
structure, just as the traditional view has always maintained, though
for somewhat different reasons. 

It is this new and currently fashionable version of the optimal
capital structure that I propose to challenge here. I will argue that 
even in a world in which interest payments are fully deductible in
computing corporate income taxes, the value of the firm, in equilibrium,
will still be independent of its capital structure.''

	- Igor.