1. Miller Channels Model Tax-class clienteles, equilibrium, and capital structure.

2. Review item  Explain why an increase in leverage doesn’t affect the value of a firm in a world without taxes or threat of bankruptcy.

3. Answer  Homemade leverage gives the investor the same effects as leverage in the firm.  Homemade leverage is costless.  Therefore investors won’t pay extra for leverage in the firm.

4. Recapitulation  Started with V U = V L  Corporate taxes  Financial distress

5. B Value, V L VuVu V L = V u + T C B Value of the firm Cost of Financial Distress

6. Indirect costs of financial distress  Lost sales, delayed collection, slow deliveries.  Managers take large risks.  Investors won’t support good projects.  Equity “milks the property.”

7. Against-the-Wall Mart AssetsBVMVLiabilitiesBVMV Cash200200LT bonds300? Fixed Asset4000Equity300? Total600200Total600200 What happens if the firm is liquidated today? LT Bonds = 200. Equity = 0.

8. Managers take bad risks Cost = $200 (all the firm’s cash) The gambleProbabilityPayoff Win Big10%$1,000 Lose Big90%$0 Required return is 50% Expected CF from the gamble = $1000 x 0.10 + $0 = $100 NPV = - $200 + $100 / 1.5 = -$133 BAD PROJECT

9. Equity accepts the bad risk  Expected CF to debt (bondholders) = 300 x 0.10 + 0 = 30  Expected CF to equity (shareholders) = (1000 - 300) x 0.10 + 0 = 70  PV of debt (bonds) without the gamble = 200  PV of equity (shares) without the gamble = 0  PV of debt (bonds) with the gamble = $30 / 1.5 = $20  PV of equity (shares) with the gamble = $70 / 1.5 = $47

10. The market won’t invest in good projects.  Government sponsored project t=0 t=1 -300 +350  Required return is 10%  NPV = -$300 + $350 / 1.1 = $18.18  GOOD PROJECT  But … the firm only has $200 now.

11. Equity passes, debt passes New bondholders contribute the 100 by buying more bonds. They get 100 or ¼ of the firm’s debt, whichever is less. When the firm gets 350, the new bondholders collect ¼*350 = 87.5. They lose. New shareholders contribute the 100: They get 50 / 1.1 - 100 = -54.55

12. Summary of “failure to contribute” Neither new equity nor new debt will contribute. Markets fail. Note: old debt would contribute if it could do so in a coordinated manner. There is an externality element. One purpose of bankruptcy is to coordinate the interests of debt.

13. Milking the Property Liquidating dividends... are often illegal … or restricted by bond indenture. Other tactics to siphon money. Perks, compensation to management. Sweetheart deals with shell companies

14. Optimal Debt and Value Debt (B) Value of firm (V) 0 Present value of tax shield on debt Present value of financial distress costs Value of firm under MM with corporate taxes and debt VL=VU+TCB=VL=VU+TCB= V=Actual value of firm V U =Value of firm with no debt B* Maximum firm value Optimal amount of debt

15. The final word on capital structure  Miller channels model.  Restores MMI with important differences

16. What's been left out so far? Investor taxes. Supply and demand.

17. Financial officers as marketers … or arbitragers. They package EBIT into either the debt channel or the equity channel, depending on which has more value.

18. Taxes in the debt channel Only T B, investor tax rate on bond income

19. Taxes in the equity channel T C the corporate tax rate T S investor tax rate on stock income Stock income is partially or largely tax shielded: unrealized capital gains net capital gains

20. Channels $ of operating cash flows TCTC Corporate taxes 1-T B (1-T C )(1-T S ) TBTB TSTS Personal taxes Debt channel Equity channel

21. Clienteles for the channels Dependent on tax rates which differ among investors

22. Clienteles for the debt channel 1-T B > (1-T C )(1-T S ) Low income investors (Low T B and T S ) Pension funds (T B = T S = 0) IRA's (low T B, T S, because deferred) Non profit organizations

23. Clienteles for the equity channel 1-T B < (1-T C )(1-T S ) High income investors (high T B, low T S ) Corporations (low T S on dividends)

24. Equilibrium of demand The debt clientele demands debt. The equity clientele demands equity. But at what prices?

25. Value as equity Value as Debt Operating C.F.’s of the whole economy D of Institutions D of rich investors V* = 1/R B V* = 1/R S as equity as debt Miller: Tax-class clienteles

26. Meaning of the Miller channels model. Economy-wide debt-equity ratio is determinate. For each firm, debt-equity ratio does not affect value.

27. Tax reform and leveraged buyouts in the late 1980's  Tax reform of 1986  Raised T C, which favors bonds  Raised T S, which also favors bonds

28. Value as equity Value as debt Operating C.F.’s of the whole economy tax reform increased debt...

29. Increase in demand for bonds Raises economy-wide debt Rewards debt-for-equity swaps and leveraged buyouts.

30. Value as equity Value as debt Operating C.F.’s of the whole economy... tax cut increased equity

31. Summary Value is unaffected by leverage, except when tax laws have changed or something else affects the demands of clienteles.

32. Review item In a world with corporate taxes, V L =V U +T C B. Why?

33. Answer: Present value of tax shield Debt and other assets are perpetuities. Let r B be the market rate for the bonds. Interest payments of Br B each year generate a tax shield of T C Br B Present value of this perpetuity is found by dividing by r B. Result is T C B.