TAXES, CORPORATE FINANCIAL POLICY AND RETURN TO INVESTORS

Abstract

IN [1] A SERIES and [2], of Franco papers Modigliani beginning with and [1] an [2], Franco Modi liani an Merton Miller unsettled both practitioners and students of corporate financial policy by demonstrating that, in the absence of distortions to market processes due to the existence of taxes, the cost of capital to a firm could not be affected by purely financial operations. In a series of subsequent papers [3], [4] and [5], Modigliani and Miller (hereafter abbreviated simply as M-M) expanded their earlier thesis to measure the impact on "optimal" corporate financial policies and capital costs of certain specific aspects of the U.S. tax structure. Throughout M-M's treatment, however, there runs an assumption that the basic arguments established in [1] and [2] are self-evident, and that taxes represent nothing beyond an unwelcome imperfection in otherwise efficiently functioning market processes. Experience teaching this material to a broad range of students convinces the present authors that the concepts embodied in M-M's analysis are quite subtle and difficult to communicate at an abstract level. They also are difficult to embody in a (more complex and realistic) corporate and individual income tax structure. Surprisingly, such pedagogic * The authors who are, respectively, Associate Professor of Finance in the Sloan School of Management, Massachusetts Institute of Technology, and Assistant Professor of Business Administration in the College of Business Administration, Boston University, wish to acknowledge support from the Ford Foundation's grant to the Sloan School for research in business ?nance. success as the authors have enjoyed usually arises from discussions of the impact on M-M's argument of the very tax induced distortions that appear most unwelcome to their basic propositions. Accordingly, an attempt will be made here to acomplish two fairly limited objectives: first, the effect on investment value of different tax structures will be used pedagogically to illustrate the basic theses propounded by Modigliani and Miller; and second, an attempt will be made to broaden this structure to one that more closely approximates the combination of corporate, personal income and capital gains taxes encountered in the U.S. today. The paper proceeds by developing a series of increasingly complex tax structures and examining their impact on a hypothetical corporation's "optimal" debt and dividend policies. Case 1 discusses the no-tax world laid out in [ 1 ] by Modigliani and Miller. Case 2 examines the impact on their propositions of corporate income taxes alone; essentially the argument presented by M-M in [3]. Case 3 considers the impact on rational debt and dividend decisions of differential personal income and capital gains taxes; considered partially by M-M in [2]. And Case 4 integrates the preceding material by considering corporate, personal income and capital gains taxes simultaneously. A summary completes the exposition. As always, rational behavior by both corporate and private investors, operat-