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The Tax Reform Act of 1986 Revisiting the Modigliani- Miller Theorem Courtney Hopley May 7, 2003

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The Tax Reform Act of 1986 Comprehensive tax reform effort Comprehensive tax reform effort Eliminated many corporate tax deductions Eliminated many corporate tax deductions Failure to address unequal tax treatment of debt and equity finance Failure to address unequal tax treatment of debt and equity finance

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The Question Has the TRA 86 had a significant long-term effect on corporate debt-utilization? Has the TRA 86 had a significant long-term effect on corporate debt-utilization?

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Economic Theory Debt vs. Equity Finance Debt vs. Equity Finance How does a firm determine its optimal capital structure? How does a firm determine its optimal capital structure?

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The Traditional Theory Each firm has an optimal capital structure Each firm has an optimal capital structure Tax effect is significant Tax effect is significant

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The Traditional Theory

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The Modigliani-Miller Theorem Firm valuation is independent of capital structure composition Firm valuation is independent of capital structure composition Tax effect is extremely small Tax effect is extremely small No advantage from increasing debt utilization No advantage from increasing debt utilization

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The Data Twenty-six corporations from 1981 to 1999 Twenty-six corporations from 1981 to 1999 Cross-section of American industries Cross-section of American industries

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The Variables Dependent Variable- Dependent Variable- Debt-to-Equity Ratio = Long Term Debt Stockholders’ Equity Stockholders’ Equity Explanatory Variables- Explanatory Variables- 1. Tax Policy Change Dummy 2. Event Variable 3. Moody’s Aaa Bond Rating

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Method Pooled time-series cross-sectional method Pooled time-series cross-sectional method TSCS REG Procedure in SAS TSCS REG Procedure in SAS

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Aggregate Results DE = – T E A + µ 1 (1.63) (-0.46) (15.30) (0.13) (1.63) (-0.46) (15.30) (0.13) Total R-Square = T= Tax E= Event A= Aaa

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Firm-by-Firm Analysis Considerable variation among firms as to significant variables Considerable variation among firms as to significant variables Tax variable is statistically significant for a number of firms Tax variable is statistically significant for a number of firms

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Conclusions On average, the TRA 86 did not increase debt-to-equity ratios significantly On average, the TRA 86 did not increase debt-to-equity ratios significantly Tax effect is small for typical firm Tax effect is small for typical firm

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Theory Conclusion

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Conclusions Different firms weigh different factors more heavily in capital structure decisions Different firms weigh different factors more heavily in capital structure decisions Each firm affected differently by public policy Each firm affected differently by public policy Belonging to an industry is only a partial determinant of significant factors Belonging to an industry is only a partial determinant of significant factors

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