TOPIC 2: TAX-BASED THEORIES OF CAPITAL STRUCTURE 1. Introduction Thus far we ignored personal taxes altogether and showed that in the presence of corporate taxes, firms would be interested in issuing as much debt as they possibly can. However, in a world with personal taxes, it is reasonable to assume that investors will be interested in after personal tax cash flows. Consequently, the tax advantage of debt at the corporate level should be traded-off against the possible tax disadvantage of debt at the personal level. Our discussion on this topic will follow Miller’s influential paper "Debt and taxes" (JF, 1977). In this paper Miller considers the trade-off between the tax advantage of debt at the corporate level and the tax disadvantage at the personal level and examines the implications of this trade-off for optimal capital structure. Miller’s conclusion is that so long as there is a continuum of investors with varying marginal rates of personal taxes, capital structure will be irrelevant, because in equilibrium, the cost of financing a project with debt and financing it with equity (and indeed the cost of any mix of debt and equity) will be the same. This conclusion restores the implications of the original M&M’s Proposition 1 despite the fact that taxes are taken into account. When Miller wrote his paper in 1977, personal tax on interest e in the ., tD, used to be higher than personal tax on equity, tE, since the tD was equal to the tax rate on ordinary e, while tE was bination of tax on dividend yield (which was equal to the ordinary tax rate) and capital gains (which was much lower than ordinary rate). Today in the ., the tax rates on all sources of e are the same. heless, capital gains still have a tax advantage because the tax on capital gains is paid only when the gain is realized. Thus, if an investor does not need his money right away, he can defer the realization well into the future and thereby enjoy in the meantime a higher w
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