Miller Channels Model
Tax-class clienteles,
equilibrium,
and capital structure.
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.
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.
Recapitulation
Started with VU = VL
Corporate taxes Financial distress
B
Value, VL
Vu
V L = V u
+ T CB
Value of the firm
Cost ofFinancialDistress
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.”
Against-the-Wall MartAssets BV MV Liabilities BV MV
Cash 200 200 LT bonds 300 ?
Fixed Asset 400 0 Equity 300 ?
Total 600 200 Total 600 200
What happens if the firm is liquidated today?
LT Bonds = 200.
Equity = 0.
Managers take bad risksCost = $200 (all the firm’s cash)
The gamble Probability Payoff
Win Big 10% $1,000
Lose Big 90% $0
Required return is 50%
Expected CF from the gamble = $1000 x 0.10 + $0 = $100
NPV = - $200 + $100 / 1.5 = -$133 BAD PROJECT
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 bonds without the gamble = 200 PV of stocks without the gamble = 0
PV of bonds with the gamble = $30 / 1.5 = $20 PV of stocks with the gamble = $70 / 1.5 = $47
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 $200 now.
Equity passes, debt passes
• New bondholders contribute the 100 by buying more bonds. They are owed 100 or ¼ of the firm’s debt.
• When the firm gets 350, the new bondholders collect ¼*350 = 87.5. They lose.
• New shareholders contribute the 100:They get 50 / 1.1 - 100 = -54.55
Summary of failure to contribute
Neither new equity nor new debt will contribute. Markets fail.
Note: old debt would contribute if it could do so in a coordinated manner. There is an externality element.
One purpose of bankruptcy is to coordinate the interests of debt.
Milking the PropertyLiquidating dividends ...are often illegal …or restricted by bond indenture.Other tactics to siphon money.Perks, compensation to
management.Sweetheart deals with shell
companies
Optimal Debt and Value
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs
Value of firm underMM with corporatetaxes and debt
VL=VU+TCB=
V=Actual value of firm
VU=Value of firm with no debt
B*
Maximumfirm value
Optimal amount of debt
The final word on capital structure
Miller channels model. Restores MMI with important
differences
What's been left out so far?
Investor taxes. Supply and demand.
Financial officers as marketers … or arbitragers.
They package EBIT into either the debt channel or the equity channel,
depending on which has more value.
Taxes in the debt channel
Only TB, investor tax rate on bond income
Taxes in the equity channel
TC the corporate tax rate
TS investor tax rate on stock income
Stock income is partially or largely tax shielded: unrealized capital gains net capital gains
Channels$ of operatingcash flows
TB
TC
TS
1-TB (1-TC)(1-TS)
Corporatetaxes
Personaltaxes
Debtchannel Equity
channel
Clienteles for the channels
Dependent on tax rates which differ among investors
Clienteles for the debt channel
1-TB > (1-TC)(1-TS)
Low income investors (Low TB and TS )
Pension funds (TB = TS = 0)
IRA's (low TB, TS, because deferred)
Non profit organizations
Clienteles for the equity channel
1-TB < (1-TC)(1-TS)
High income investors (high TB, low TS )
Corporations (low TS on dividends)
Equilibrium of demand
The debt clientele demands debt. The equity clientele demands equity. But at what prices?
Value asequity
Value asDebt
Operating C.F.’s ofthe whole economy
D of InstitutionsD of ric
h investors
V* = 1/RB V* = 1/RS
as equityasdebt
Miller: Tax-class clienteles
Meaning of the Miller channels model.
Economy-wide debt-equity ratio is determinate.
For each firm, debt-equity ratio does not affect value.
Tax reform and leveraged buyouts in the late 1980's
Tax reform of 1986 Raised TC, which favors bonds
Raised TS, which also favors bonds
Value asequity
Value asdebt
Operating C.F.’s ofthe whole economy
tax reform
increaseddebt
...
Increase in demand for bonds
Raises economy-wide debt Rewards debt-for-equity swaps and leveraged buyouts.
Value asequity
Value asdebt
Operating C.F.’s ofthe whole economy
...
tax cut
increasedequity
Summary
Value is unaffected by leverage,
except when tax laws have changed
or something else affects the demands of clienteles.
Review item
In a world with corporate taxes, VL=VU+TCB. Why?
Answer: Present value of tax shield
Debt and other assets are perpetuities. Let rB be the market rate for the bonds.
Interest payments of BrB each year generate a tax shield of TCBrB
Present value of this perpetuity is found by dividing by rB. Result is TCB.