DEBT AND TAXES*

Abstract

The somewhat heterodox views about debt and taxes that will be presented here have evolved over the last few years in the course of countless discussions with several of my present and former colleagues in the Finance group at Chicago—Fischer Black, Robert Hamada, Roger Ibbotson, Myron Scholes and especially Eugene Fama. Charles Upton and Joseph Williams have also been particularly helpful to me recently in clarifying the main issues.11 More than perfunctory thanks are also due to the many others who commented, sometimes with considerable heat, on the earlier versions of this talk: Ray Ball, Marshall Blume, George Foster, Nicholas Gonedes, David Green, E. Han Kim, Robert Krainer, Katherine Miller, Charles Nelson, Hans Stoll, Jerold Warner, William Wecker, Roman Weil, and J. Fred Weston. I am especially indebted (no pun intended) to Fischer Black. My long-time friend and collaborator, Franco Modigliani, is absolved from any blame for the views to follow not because I think he would reject them, but because he has been absorbed in preparing his Presidential Address to the American Economic Association at this same Convention. This coincidence neatly symbolizes the contribution we tried to make in our first joint paper of nearly twenty years ago; namely to bring to bear on problems of corporate finance some of the standard tools of economics, especially the analysis of competitive market equilibrium. Prior to that time, the academic discussion in finance was focused primarily on the empirical issue of what the market really capitalized.22 To avoid reopening old wounds, no names will be mentioned here. References can be supplied on request, however. Did the market capitalize a firm's dividends or its earnings or some weighted combination of the two? Did it capitalize net earnings or net operating earnings or something in between? The answers to these questions and to related questions about the behavior of interest rates were supposed to provide a basis for choosing an optimal capital structure for the firm in a framework analogous to the economist's model of discriminating monopsony. We came at the problem from the other direction by first trying to establish the propositions about valuation implied by the economist's basic working assumptions of rational behavior and perfect markets. And we were able to prove that when the full range of opportunities available to firms and investors under such conditions are taken into account, the following simple principle would apply: in equilibrium, the market value of any firm must be independent of its capital structure. The arbitrage proof of this proposition can now be found in virtually every textbook in finance, followed almost invariably, however, by a warning to the student against taking it seriously. Some dismiss it with the statement that firms and investors can't or don't behave that way. I'll return to that complaint later in this talk. Others object that the invariance proposition was derived for a world with no taxes, and that world, alas, is not ours. In our world, they point out, the value of the firm can be increased by the use of debt since interest payments can be deducted from taxable corporate income. To reap more of these gains, however, the stockholders must incur increasing risks of bankruptcy and the costs, direct and indirect, of falling into that unhappy state. They conclude that the balancing of these bankruptcy costs against the tax gains of debt finance gives rise to an optimal capital structure, just as the traditional view has always maintained, though for somewhat different reasons. It is this new and currently fashionable version of the optimal capital structure that I propose to challenge here. I will argue that even in a world in which interest payments are fully deductible in computing corporate income taxes, the value of the firm, in equilibrium will still be independent of its capital structure. Let me first explain where I think the new optimum capital structure model goes wrong. It is not that I believe there to be no deadweight costs attaching to the use of debt finance. Bankruptcy costs and agency costs do indeed exist as was dutifully noted at several points in the original 1958 article 28, [see especially footnote 18 and p. 293]. It is just that these costs, by any sensible reckoning, seem disproportionately small relative to the tax savings they are supposedly balancing. The tax savings, after all, are conventionally taken as being on the order of 50 cents for each dollar of permanent debt issued.33 See, among others, Modigliani and Miller 27. The 50 percent figure—actually 48 percent under present Federal law plus some additional state income taxes for most firms—is an upper bound that assumes the firm always has enough income to utilize the tax shield on the interest. For reestimates of the tax savings under other assumptions with respect to availability of offsets and to length of borrowing, see Kim 21 and Brennan and Schwartz 12. The estimate of the tax saving has been further complicated since 1962 by the Investment Tax Credit and especially by the limitation of the credit to fifty percent of the firm's tax liability. Some fuzziness about the size of the tax savings also arises in the case of multinational corporations. The figure one usually hears as an estimate of bankruptcy costs is 20 percent of the value of the estate; and if this were the true order of magnitude for such costs, they would have to be taken very seriously indeed as a possible counterweight. But when that figure is traced back to its source in the paper by Baxter 5 (and the subsequent and seemingly confirmatory studies of Stanley and Girth 36 and Van Horne 39), it turns out to refer mainly to the bankruptcies of individuals, with a sprinkling of small businesses, mostly proprietorships and typically undergoing liquidation rather than reorganization. The only study I know that deals with the costs of bankruptcy and reorganization for large, publicy-held corporations is that of Jerold Warner 40. Warner tabulated the direct costs of bankruptcy and reorganization for a sample of 11 railroads that filed petitions in bankruptcy under Section 77 of the Bankruptcy Act between 1930 and 1955. He found that the eventual cumulated direct costs of bankruptcy—and keep in mind that most of these railroads were in bankruptcy and running up these expenses for over 10 years!—averaged 5.3 percent of the market value of the firm's securities as of the end of the month in which the railroad filed the petition. There was a strong inverse size effect, moreover. For the largest road, the costs were 1.7 percent. And remember that these are the ex post, upper-bound cost ratios, whereas, of course, the expected costs of bankruptcy are the relevant ones when the firm's capital structure decisions are being made. On that score, Warner finds, for example, that the direct costs of bankruptcy averaged only about 1 percent of the value of the firm 7 years before the petition was filed; and when he makes a reasonable allowance for the probability of bankruptcy actually occurring, he comes up with an estimate of the expected cost of bankruptcy that is, of course, much smaller yet. Warner's data cover only the direct costs of reorganization in bankruptcy. The deadweight costs of rescaling claims might perhaps loom larger if measures were available of the indirect costs, such as the diversion of the time and energies of management from tasks of greater productivity or the reluctance of customers and suppliers to enter into long-term commitments.44 For more on this theme see Jensen and Meckling 20. But why speculate about the size of these costs? Surely we can assume that if the direct and indirect deadweight costs of the ordinary loan contract began to eat up significant portions of the tax savings, other forms of debt contracts with lower deadweight costs would be used instead.55 A similar argument in a somewhat different, but related, context is made by Black 6, [esp. pp. 330–31]. Note also that while the discussion has so far referred exclusively to "bankruptcy" costs fairly narrowly construed, much the same reasoning applies to the debt-related costs in the broader sense, as in the "agency" costs of Jensen and Meckling 20 or the "costs of lending" of Black, Miller and Posner 9. An obvious case in point is the income bond. Interest payments on such bonds need be paid in any year only if earned; and if earned and paid are fully deductible in computing corporate income tax. But if not earned and not paid in any year, the bondholders have no right to foreclose. The interest payments typically cumulate for a short period of time—usually two to three years—and then are added to the principal. Income bonds, in sum, are securities that appear to have all the supposed tax advantages of debt, without the bankruptcy cost disadvantages.66 Not quite, because failure to repay or refund the principal at maturity could trigger a bankruptcy. Also, a firm may have earnings, but no cash. Yet, except for a brief flurry in the early 1960's, such bonds are rarely issued. The conventional wisdom attributes this dearth to the unsavory connotations that surround such bonds.77 See Esp. Robbins 31, 27. They were developed originally in the course of the railroad bankruptcies in the 19th century and they are presumed to be still associated with that dismal process in the minds of potential buyers. As an investment banker once put it to me: "They have the smell of death about them." Perhaps so. But the obvious retort is that bit of ancient Roman wisdom: pecunia non olet (money has no odor). If the stakes were as high as the conventional analysis of the tax subsidy to debt seems to suggest, then ingenious security salesmen, investment bankers or tax advisers would surely long since have found ways to overcome investor repugnance to income bonds. In sum, the great emphasis on bankruptcy costs in recent discussions o

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