Corporate Income Taxes, Valuation, and the Problem of Optimal Capital Structure

Most aspects of the theory of capital structure and valuation in perfect capital markets with no corporate income tax have by now been investigated.' Somewhat less attention, however, has been directed to the effects of the corporate income tax on the relationship between capital structure and valuation,2 although it is the corporate income tax which lends most of the interest to the optimal capital structure problem and although the conclusions reached by Modigliani and Miller (1963) were much more tentative when corporate income taxes were introduced. Analysis of the effects of the corporate income tax is of interest not only because corporate income taxes do in fact exist but because the analysis appears to lead to the conclusion that an optimal capital structure will consist almost entirely of debt. This conclusion leads to inconsistency between the premise that managements act so as to maximize the wealth of stockholders and the empirical observation that most firms eschew highly levered capital structures. Modigliani and Miller themselves attribute this discrepancy beThis paper is concerned mainly with the effects of corporate income taxes on the relationship between capital structure and valuation. If the interest tax savings cease once a firm has gone bankrupt, it is apparent that the issue of additional debt will have two effects on the value of the firm: on one hand, it will increase the tax savings to be enjoyed so long as the firm survives; on the other hand, it will reduce the probability of the firm's survival for any given period. Depending on which of these conflicting influences prevails, the value of the firm may increase or decrease as additional debt is issued. The option pricing framework is used to relate the value of a levered firm to the value of an unlevered firm, the amount of debt, and the time to maturity of the debt. * The authors are grateful to Robert Hamada for helpful comments. 1. Durand (1952), Modigliani and Miller (1958), Solomon (1963), Stiglitz (1969, 1972), Smith (1972), and Milne (1975). 2. See, however, Hamada (1969), Kraus and Litzenberger (1973), and Rubinstein (1973).