Leverage Policy

Zoom Session 5
 References:
Chapter 14 of Brigham, E.F. and Houston, J.F., 2015. 13th
Edition. Fundamentals of financial management. Cengage

Chapter 16 & 17 Ehrhardt, M. C., & Brigham, E. F. (2011).

Financial management: theory and practice. South-Western
Cengage Learning.
CAPITAL STRUCTURE THEORY
MM (Modigliani and Merton Miller) proved in 1958, under a restrictive set of
assumptions, that a firm’s value should be unaffected by its capital structure.
Here is a partial Listing of their assumptions:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s
future investment opportunities.
6. EBIT is not affected by the use of debt.
 MM Theory
• Conclusion: that capital structure is irrelevant
• MM provided clues about what is required to make capital
structure relevant and hence to affect a firm’s value
• MM’s work marked the beginning of modern capital
structure research, and subsequent research has focused
on relaxing the MM assumptions to develop a more
robust and realistic theory.
 The Effect of Taxes
• MM’s original 1958 paper was criticized harshly, and they
published a follow-up in 1963 that relaxed the assumption
of no corporate taxes.
• They recognized that the Tax Code allows corporations to
deduct interest payments as an expense, but dividend
payments to stockholders are not deductible.
• Conclusion: this differential treatment leads to an optimal
capital structure of 100% debt.
 The Effect of Taxes
• MM’s 1963 work was modified several years later by Merton Miller, when
he brought in the effects of personal taxes.

Debt
• bonds pay interest,
• taxed as personal income
at rates going up to 35%,
Stock
• Dividends and capital gains So on balance, returns on
• Capital gains are taxed at a common stocks are taxed at
max. rate of 15%, lower effective rates than re-
• This tax can be deferred turns on debt
until the stock is sold & re-
alized
 The Effect of Taxes
(1) the deductibility of interest favors the use of debt
financing, but
(2) the more favorable tax treatment of income from stocks
favors the use of equity.
• Conclusion: It is difficult to specify the net effect of these
two factors. However, most observers believe that interest
deductibility has a stronger effect and hence that our tax
system favors the corporate use of debt.
Thank you!