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.

• Can old debt contribute?• Not outside of bankruptcy because

equity has other incentives. • Later, a bankruptcy court might arrange

it. • Markets fail.

Milking the Property

Liquidating dividends ...are often illegal …or against the indenture.Other tactics to siphon money.Sweetheart deals, perks,

compensation.

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

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

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?

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.