Chapter 4 Corporate Taxation

Transcription

1 Chaper 4 Corporae Taxaion 4.1 Inroducion The corporaion is reaed as a separae eniy for ax purposes in all developed counries. I has been subjec of numerous ax insrumens wih a variey of differen moivaions. The ransfers beween he corporaion and is sock-holders resul in he behavior of he corporaion also being influenced by he srucure of he personal ax sysem, mos noably hrough he favorable ax reamen of capial gains. There are wo raionales for corporae axaion: 1. If he corporaion is seen merely as earning income and ransmiing his o is ulimae owners, hen here is no reason why he corporaion should be axed. Insead, he ax liabiliy should be placed upon is owners alone. This argumen reflecs he view ha he corporaion does no have a personaliy or exisence of is own oher han ha given o i in law. In simple seing where shareholders exercise direc conrol, he corporaion canno be idenified as an eniy disinc from is owners. A coheren ax srucure would hen involve a comprehensive income ax on owners, covering all sources of earnings, wih no need for separae axaion of he corporaion. 2. The alernaive perspecive is ha incorporaion carries legal and economic privileges and ha he corporaion ax is a ax upon he gains enjoyed from he benefi of hese privileges, in paricular ha of limied liabiliy. Anoher privilege is ha he ax falls primarily on pure profis and hence is less disorionary han axes on oher kinds of income. Perhaps mos imporan in poliical erms is he belief ha i is borne by corporaions raher han individuals and is herefore relaively painless. Ulimaely (pracically), he effec of a ax depends upon how i affecs he individuals in he economy and he correcness, or oherwise, of axing he corporaion depends upon he final incidence of he ax. If he ax can achieve objecives ha oher axes canno, and so raise social welfare, hen here is a jusificaion for is exisence. 4.2 Types of Taxes There are many differen ypes of ax ha are imposed on firms. 1. Taxes on individual facors Lecures on Public Finance Par2_Chap4, 2015 version Page 1 of 47

2 The mos common kind of ax on labor is a payroll ax, usually levied as a fixed percenage of he wage bills (e.g. he social securiy ax). The converse of a payroll ax is where he governmen provides wage subsidies. The corporae profi ax is someimes viewed as a ax on he reurn o capial in he corporae secor. Bu he ineres deducibiliy implies ha he ax falls primarily on pure profis, no on he reurn o capial. As here are wage subsidies, here are subsidies for invesmen: invesmen ax credis or grans. Taxes on facors may be general axes or confined o paricular forms of inpu or o paricular aciviies. Thus paymens o bond holders are generally exemp from corporae profis ax and reurns in he form of an increase in he value of an asse (capial gains) are reaed differenly from oher reurns. Dividends are axed. 2. Taxes on oal oupu or oal inpu. The Value Added Tax (VAT), a proporionae ax on he value added by he firm. On an income base, value added is defined as wage paymen plus he reurn o capial (ne of depreciaion) (equivalen o a uniform payroll ax plus an equal rae profis ax). There are he produc base and he consumpion base, which is equivalen o a uniform payroll ax plus an equal rae profis ax wih free depreciaion. Producion and urnover axes are levied on he value of gross oupu of a firm (e.g. The impac on he degree of inegraion in he economy needs o be considered. Gross urnover axes may provide an incenive for verical inegraion). 4.3 Changing Views of Corporae Income Tax 1 In Table 1 I have ried o summarize he mos well-known compeing heories of corporae income axaion 2. The saemens regarding he cos of capial assume ha axable profis are equal o he rue economic profis, i.e., ha depreciaion for ax purposes corresponds o he rue economic depreciaion of he firm s asses 3. The following secions provide some explanaory remarks o he able. 1 This par is drawn from Sørensen (1999) 2 For more deailed surveys, see Auerbach (1983), Poerba and Summers (1985), Sinn (1991a), or Sørensen (1995). 3 In he nex par of he paper, we shall consider he complicaions arising from deviaions beween axable profis and rue economic profis. Lecures on Public Finance Par2_Chap4, 2015 version Page 2 of 47

3 Table 1 Alernaive Views of he Classical Corporae Tax Sysem Theory Influence of Nonax Facors on Corporae Financing Decisions Marginal Source of Finance Marginal Use of Profis Old view b Imporan New equiy imporan Dividend paymens Neuraliy view c Unimporan Deb Financial invesmen in capial marke New view d Unimporan Reained earnings Dividend paymens Nucleus heory of he firm e Growh phase Mauriy phase Unimporan A ime of esablishmen: new equiy afer ime of esablishmen: reained earnings Reinvesmen in real capial Unimporan Reained earnings Dividend paymens Cos of Corporae Capial a High above marke ineres rae Equal o marke ineres rae Slighly above marke ineres rae Saring very high above marke ineres rae, bu falling over ime Slighly above marke ineres rae Effec of Dividend Tax Relief Significan simulus o corporae invesmen No simulus o invesmen Windfall gains o exising shareholders; no invesmen simulus Significan simulus o he esablishmen and growh of new corporaions Windfall gains o exising shareholders; no invesmen simulus a The saemens in his column assume rue economic depreciaion. b Elaboraed by numerous wriers over he years, bu heavily influenced by Harberger (1962, 1966). c Reaching is mos developed form in Sigliz (1973). d Developed and elaboraed by King (1974a, b, 1977), Auerbach (1979), Bradford (1980, 1981) and Sinn (1985). e Developed by Sinn (1991b). The Old View of he Corporaion Tax According o he radiional view also referred o as he old view a classical corporae ax sysem will disor he financing as well as he real invesmen decisions of corporaions. Since ineres paymens are deducible from he corporae income ax base, hence escaping double axaion, here is a endency for deb finance o be subsiued for equiy finance. Moreover, since he shareholder s personal ax on capial gains is deferred unil he ime of realizaion, whereas his dividend income is axed immediaely, corporaions are induced o generae capial gains o shareholders by reaining par of heir profis raher han paying hem ou as dividends. To some exen, he subsiuion of deb finance for equiy finance and he replacemen of new equiy by reained profis will reduce he impac of axaion on he cos of corporae capial. However, according o he old view, corporaions will sill wish o rely on some amoun of equiy finance a he margin, including some amoun of new equiy. The double axaion of corporae equiy income will herefore reduce he overall level of saving and invesmen and drive he required preax rae of reurn on corporae invesmen above he preax rae of reurn required in he noncorporae secor. As a resul, oo lile capial is allocaed o he corporae secor, and oo much is allocaed o he noncorporae secor, as seen from sociey s viewpoin. To explain why corporaions would wan o use some amoun of equiy finance a he margin despie he ax-preferred saus of deb finance, he holders of he old view ypically argue ha high deb equiy raios generae cerain invisible coss semming from he risks of Lecures on Public Finance Par2_Chap4, 2015 version Page 3 of 47

4 financial disress and bankrupcy. A some leverage raio well below a hundred percen he rise in hese coss will ouweigh he ax benefis of increased reliance on deb finance. The old view also assumes ha shareholders have a nonax preference for dividends over capial gains on shares. Oher hings equal, shareholders will hus require a lower afer-ax reurn on shares in corporaions wih higher dividend pay-ou raios. Up o a poin, he corporaion is herefore able o reduce is cos of equiy finance by raising is pay-ou raio. Since new share issues increase he abiliy of he corporaion o pay dividends o exising shareholders, i becomes opimal for he value-maximizing corporaion o rely o some exen on new equiy raher han using only reained profis as he source of equiy finance. In principle, he corporaion will raise is dividend pay-ou raio o he poin where he marginal nonax benefis from increased dividend paymens are jus offse by he ax penaly on dividends, wih he ax penaly being equal o he difference beween he personal ax rae on dividends and he effecive personal ax rae on (accrued) capial gains on shares. Proponens of he old view do no always make very clear why shareholders would require lower ne reurns on shares wih higher dividend pay-ou raios. The mos popular hypohesis is ha dividends serve as a signal o he sock marke ha he corporaion is financially healhy and faces brigh earnings prospecs. Criics have found his heory raher unconvincing, arguing ha a corporaion faced wih profiable invesmen opporuniies should reain and reinves is profis raher han paying hem ou. The Neuraliy Hypohesis The criics of he old view end o downgrade he imporance of nonax facors for corporae financing decisions. The poin of deparure for hese skepics is he so-called Modigliani-Miller heorem, according o which shareholders would be indifferen o he corporaion s financial policy in a world wihou axes, since invesors would always be able o neuralize he effecs of he firm s borrowing and dividend policy on he risk-reurn profiles of heir personal porfolios by selling from or borrowing agains heir porfolios. If he various modes of finance are in fac equally aracive from a nonax poin of view, i follows ha he corporaion should rely exclusively on he source of finance ha is mos favored by he ax sysem. In mos counries, he mode of finance would be deb, because equiy-financed invesmen ends o be subjec o double axaion. If deb is used as he marginal source of finance, and axable profis coincide wih acual profis, i will be profiable for he corporaion o carry is real invesmen o he poin where he risk-adjused marginal preax rae of reurn is jus equal o he (deducible) marke rae of ineres before ax. In oher words, he opimal invesmen policy of he corporaion would be idenical o he opimal policy in a hypoheical world of Lecures on Public Finance Par2_Chap4, 2015 version Page 4 of 47

5 zero axes, and he corporaion ax would be neural, falling only on he inframarginal profis exceeding he marke ineres rae. Sigliz (1973) argued ha he corporae income ax will also be neural if he oal corporae and personal ax burden on reained earnings is lower han he personal ax on ineres income so ha finance by reenions is ax-preferred o deb finance. In his siuaion which Sigliz believed o prevail in he U.S. before he 1981 ax reform he corporaion should underake reenions-financed real invesmen unil he marginal rae of reurn becomes equal o he marke ineres rae, and he remaining profis (if any) should be used for financial invesmen in he capial marke. In he absence of nonax benefis from dividend paymens, i is no raional o pay ou any dividends if disribuions are penalized by he ax sysem, and if financial invesmen underaken hrough he corporaion is axed more lighly han financial invesmen underaken direcly by he shareholders hemselves 4. Furhermore, i would obviously no be raional for he corporaion o carry ou real invesmen wih a reurn below he marke ineres rae when i could alernaively inves in financial asses. I should be clear ha such a ax regime is really equivalen o a regime of deb finance: o increase is real invesmen by one dollar, he corporaion will have o reduce is financial invesmen by one dollar, so he opporuniy cos of real invesmen is he ineres rae ha migh have been earned in he capial marke. In shor, he cos of corporae capial equals he going ineres rae, and again he corporaion ax falls only on he inframarginal invesmens wih reurns above he marke rae of ineres. The New View The neuraliy hypohesis does no square wih he observaions ha mos corporaions do end o pay dividends on a regular basis and ha hey rarely rely exclusively on deb finance a he margin. The so-called new view of he corporaion ax assumes ha corporaions pay dividends and acceps he fac ha firms will ypically wish o use some amoun of equiy finance a he margin. However, according o he new view here is no convincing reason why shareholders should prefer a dollar of ne dividend o a dollar of ne capial gain on shares. Insead, i is argued ha a maure corporaion earning sufficien profis should mee all of is need for equiy finance hrough reenions and should pay ou only he remaining profi as dividends. A maure corporaion operaing under a classical corporae ax sysem should never subsiue new share issues for reained earnings, since his would ransform lighly axed capial gains on shares ino more heavily axed dividends. Since he new view assumes ha reained profis are he marginal source of corporae 4 For he corporaion o have a posiive marke value, i mus ulimaely reurn cash o is shareholders. Sigliz (1973) assumed ha his would be done by liquidaing he firm a some poin. Lecures on Public Finance Par2_Chap4, 2015 version Page 5 of 47

6 finance, i implies ha he corporaion s marginal invesmen will generae an addiional capial gains liabiliy for shareholders, because increased reenions will end o raise he marke value of ousanding shares. If he combined corporae and personal ax burden on reenions (i.e., he sum of he corporae income ax on reenions and he personal ax on capial gains on shares) exceeds he shareholder s personal ax on ineres income, he required rae of reurn on corporae invesmen will exceed he marke ineres rae. On he oher hand, he new view has he sriking implicaion ha axes on disribued profis are neural. While i is rue ha dividend axes reduce he shareholder s income from addiional invesmen, hey also reduce his opporuniy cos of allowing he firm o reain profis for furher invesmen. Thus, if he oal corporae and personal ax burden on a dollar of disribued profis is 50 cens, he shareholder only has o give up a ne income of 50 cens for each dollar reained for invesmen by he corporaion. This 50 percen reducion of he opporuniy cos of invesmen fully compensaes for he 50 percen dividend ax levied when he profis on he exra invesmen are ulimaely paid ou, leaving he shareholder s ne reurn unaffeced by he ax burden on disribuions. Hence, axes on dividends have no influence on he cos of corporae capial, bu are merely capialized in share prices in order o ensure ha invesmen in shares is jus as aracive as invesmen in ineres-bearing asses, despie he double axaion of dividends. One may also say ha equiy is rapped wihin he corporaion in he sense ha he funds accumulaed wihin he firm will ineviably have o bear he dividend ax, wheher disribuions are made now or laer. For a consan dividend ax rae, an invesmen policy ha maximizes he presen value of disribuions before dividend ax will herefore also maximize he presen value of dividends afer ax. Hence he neuraliy of he dividend ax. The new view hus implies ha measures o alleviae he double axaion of dividends will no simulae corporae invesmen, leading only o a windfall gain o exising shareholders and a corresponding loss of governmen revenue. According o he new view, policymakers should focus insead on he double axaion of reained earnings resuling from he coexisence of he corporae income ax and he personal ax on capial gains on shares. However, since he effecive ax rae on accrued capial gains is ypically raher low because he ax is deferred unil he ime of realizaion of he gain, he new view also suggess ha he problem of double axaion is no very serious and ha he cos of corporae capial is probably no very far above he marke ineres rae, even in counries like he Unied Saes where realized long-erm capial gains on shares are included in he personal income ax base 5. 5 Criics have argued ha he surge in share repurchases observed in he Unied Saes during he las decade undermines he assumpion underlying he new view ha cash disribuions o shareholders ake he form of dividends. However, as Sinn (1991a, sec. 7.1) has demonsraed, a corporaion financing is marginal invesmen by new share issues (or, equivalenly, by a reducion in share repurchases) and using is marginal profis o Lecures on Public Finance Par2_Chap4, 2015 version Page 6 of 47

7 Reconciling he Old and he New View: The Nucleus Theory of he Firm If revenue-generaing dividend axes are neural, one migh be emped o conclude ha policy makers should increase he ax burden on dividends raher han worry abou measures o alleviae he exising double axaion. This conclusion would be oo hasy, however, since he new view explained above applies only o maure firms earning sufficien profis o be able o mee heir need for equiy finance hrough reained earnings. Holders of he new view do no deny ha newly esablished firms or rapidly growing firms ha have o rely on new share issues will face a higher cos of capial when dividends are subjec o double axaion. Since shareholders are no eniled o a ax deducion for heir purchase of shares, heir opporuniy cos of invesmen will no be reduced by he dividend ax rae, as is he case when he firm finances invesmen by wih-holding dividends. The ne reurn o invesmen will herefore be reduced by he full amoun of he dividend ax, and he cos of capial will be correspondingly higher, when new equiy is he marginal source of finance and marginal profis are paid ou as dividends. I would hus seem ha he old view may be relevan for immaure or rapidly growing firms even if he new view provides a correc descripion of maure firms. Ye, i has been argued by Sinn (1991b) ha he cos of capial for an immaure firm will be even higher han prediced by he old view. The old view suggess ha a corporaion ha is abou o be se up should immediaely issue he amoun of shares necessary o carry invesmen o he poin where he marginal reurn jus compensaes for he exra ax on dividends relaive o ineres income. However, Sinn (1991b) poins ou ha if reenions are axed more lighly han disribuions, i may be opimal for a corporaion in he sar-up phase o issue a smaller amoun of shares han his invesmen rule would sugges. The reason is ha he ax sysem provides an incenive o pospone invesmen unil he firm begins o make profis so ha i can finance invesmen ou of ax-preferred reenions. If i only has a limied number of invesmen projecs wih above-normal raes of reurn, he new firm foregoes he possibiliy of financing hese invesmens by cheaper capial (reenions) a a laer dae if i raises new equiy oday in order o implemen all projecs a once. The loss of he opporuniy o use a cheaper mode of finance a a laer sage represens an addiional opporuniy cos of curren invesmen for he immaure firm ha mus be added o he cos of capial. According o Sinn (1991b), a new corporaion should herefore issue only a limied amoun of new shares a he ime of foundaion i.e., i should sar only wih a small nucleus of equiy in order o carry ou only he mos profiable of is planned invesmen projecs. The remaining projecs wih relaively high reurns should be financed exclusively ou of reained repurchase shares would in fac have exacly he same cos of capial as implied by he new view. Lecures on Public Finance Par2_Chap4, 2015 version Page 7 of 47

8 earnings in he subsequen growh phase of he firm, and no dividends should be paid during his phase, since his would ransform lighly axed capial gains ino heavily axed dividends. The greaer he ax discriminaion agains disribuions relaive o reenions, he lower should be he iniial injecion of equiy, and he greaer should be he volume of invesmen financed by reenions in he subsequen growh phase. The growh phase comes o an end when he capial sock has expanded o he poin where addiional invesmen no longer yields above-normal raes of reurn. The corporaion hen eners he sage of mauriy, where ne invesmen becomes zero and where profis are paid ou as dividends. In his phase, he rapped-equiy argumen applies, i.e., he dividend ax becomes neural, and he cos of capial becomes equal o he value implied by he new view. The poin is, however, ha under very mild condiions he iniial cos of capial is even higher han suggesed by he old view a he ime he firm is se up. Moreover, he cos of capial remains above he value prediced by he new view during he drive o mauriy. The reason is ha he gradual fall in he marginal produciviy of capial during he growh phase will generae a gradual capial loss o shareholders for which hey mus be compensaed by an above normal rae of reurn on he corporaion s real invesmen. Noice he paradoxical implicaion of his dynamic heory of he corporae firm: he double axaion of dividends will drive up he cos of capial during he growh phase where he firm does no pay dividends and no dividend ax is colleced, whereas he dividend ax will be neural in he mauriy phase where dividends are acually paid and he ax begins o yield revenue! Table 2 Effecs of he Corporae Tax Sysem under Alernaive Accouning Regimes a Accouning Regime Uniform reporing ( One-book sysem) Separae reporing ( Two-book sysem) Unimporan Corporae income ax rae neural Dividend axaion neural Invesmen simulaed by acceleraed depreciaion Role of Monioring Coss Significan monioring cos savings from deb finance Corporae income ax rae neural Dividend axaion neural Acceleraed depreciaion ineffecive Corporae income ax rae non-neural ( axaion paradox ) dividend axaion neural Significan monioring cos savings from exernal finance Corporae income ax rae non-neural Dividend axaion non-neural Acceleraed depreciaion ineffecive Corporae income ax rae non-neural Dividend axaion non-neural Invesmen simulaed by acceleraed depreciaion Invesmen simulaed by acceleraed depreciaion a The able summarizes he finding of Kanniainen and Södersen (1994a, b) and Sørensen (1994, 1995). All resuls repored in he able are based on he assumpion ha marginal profis are paid ou as dividends. The recen heories sressing he imporance of accouning convenions for he cos of Lecures on Public Finance Par2_Chap4, 2015 version Page 8 of 47

9 corporae capial are summarized in Table 2. As saed in he able, he presence of monioring cos savings from deb finance does no eliminae he firm s incenive o ake full advanage of allowances for acceleraed depreciaion under separae reporing (see Sørensen, 1994, Appendix). The reason is ha his accouning regime does no consrain he use of deb finance o he same exen as he regime of uniform reporing. I should be added ha he monioring-cos heory skeched here is no he only possible explanaion why corporaions in one-book (uniform-reporing) counries may no wish o exploi all available depreciaion allowances. As Cummings, Harris, and Hasse (1994) has poined ou, firms in one-book counries may also be relucan o claim all poenial ax benefis if reducions in axable income may be misinerpreed by financial markes as signals of lower profiabiliy. Indeed, hese auhors find empirical evidence ha invesmen in one-book counries is less sensiive o ax-law changes han invesmen in wo-book counries allowing separae reporing. This underscores he imporance of analyzing a counry s accouning regime when evaluaing he incenive effecs of he corporaion ax. Profi ax Wih full allowance for capial expendiure, he firm will opimize, by choice of capial and labor, he level of afer-ax profis are given by [ ] π = ( 1 c ) pf( K, L) wl rk (1) As he firs-order condiions for profi maximizaion, p F k = r p F = w L he firm s opimal choice of inpus is unaffeced by he imposiion of he ax. The resuls are modified if paymens o capial can no be deduced before ax. [ ] π = ( 1 c ) pf( K, L) wl rk (2) rk can be inerpreed as he cos of capial, The definiion of ax base is he key. There are difficulies in depreciaion, depleion, invenory accumulaion, capial gains and losses, and inercorporae dividends. Lecures on Public Finance Par2_Chap4, 2015 version Page 9 of 47

10 4.4 Financial Srucure The analysis focuses on he fundamenal financial ideniy of he firm. 1. gross profis π = pf wl 2. New bond issues B + 1 B 3. New equiy issues θ + 1 θ We can idenify he following disbursemens: 1. dividends D 2. ineres paymens o bondholders rb 3. invesmen I The fundamenal relaionship is ha revenues equal disbursemens are period. π + B + 1 B + θ + 1 θ = D + I + rb (3) Reained earnings, RE = π rb D (4) Then (3) becomes I = RE + ( B B ) + ( θ θ ) (5) Invesmen is financed by reained earnings, borrowing or new equiy issues. In he absence of axaion, he ne financial flow from he corporaion o he personal secor is Y = D + rb ( B B ) ( θ θ ) (6) This is equal o Y = π I. The ne flow is deermined by he real variables and does no depend a all on he financial srucure. I is formally saed in he following: The Modigliani-Miller Theorem: in he absence of axaion and bankrupcy, corporae financial policy is irrelevan and has no effec on he value of he firm. Lecures on Public Finance Par2_Chap4, 2015 version Page 10 of 47

11 We inroduce he ax sysem (he classical sysem) 1. corporae profis ax c 2. ineres paymens by corporaions are deducible. 3. ineres paymens by individuals are deducible a he personal ax rae, p. 4. dividends and ineres received are axable a p. 5. capial gains are axable a g < p. One problem wih he classical sysem is he double axaion of dividends: hey are axed once as corporae profi and hen again as personal income. The impuaion sysem aemps o avoid his double axaion by inegraing he corporae and personal ax sysems. I does his by giving each shareholder a credi for he ax paid by he company on he profi ou of which dividends are paid. In essence, any profis disribued as dividends are deemed o have already been subjec o personal ax a wha is known as he rae of impuaion. The shareholder receiving he dividend is hen only liable for he difference beween he rae of impuaion and heir personal ax rae. is, Wih his ax sysem, he corporae ax liabiliy is π rb ) and he financial ideniy c ( π ) B (7) ( 1 c ) + ( B+ 1 B ) + ( θ + 1 θ ) = D + I + r(1 c For he personal secor, here is liabiliy o income ax and capial gains ax, so ha he ne financial flow afer ax is Y = ( D + rb )( ) ( B B ) ( θ θ ) (8) 1 p A furher alernaive sysem ha has been employed in U.K., Germany and Japan is he wo-rae (spli-rae) sysem. Under his sysem, differen ax raes apply o disribued and undisribued profis wih he laer being axed a a higher rae. The main reason for his sysem is no o alleviae he double axaion of dividends in view of inegraion, bu o improve he working of he securiies markes and encourage saving and invesmen. Lecures on Public Finance Par2_Chap4, 2015 version Page 11 of 47

12 Table 3 Types of Corporae Taxaion in OECD, 1987 Type of Taxaion Separae Corporae Tax (X) Pure Classical sysem Sligh alleviaion a company level (X1) Sligh alleviaion a shareholder level (X2) Parial Inegraion (Y) A company level (spli rae) (Y1) A shareholder level (impuaion) (Y2) Credi for company ax acually wihheld (Y2(a)) Credi for domesic ax deemed o have been paid (Y2(b)) Full Assimilaion (Z) A company level (Z1) A shareholder level (Z2) Source: OECD (1987) p.86. Counry Ausralia Sweden USA (Japan) Japan (Germany) UK Canada Greece Germany Table 3 illusraes many ways of avoiding he double axaion of dividends in As we discussed above, here are hree broad ypes of he corporae ax sysem: he separae sysem (X), he spli rae sysem (Y1), and he impuaion sysem (Y2). The full assimilaion (full inegraion) does no seem o be a pracical mehod of inegraion. According o Ishi (1993, pp.187-8), Japan is characerized by a hybrid ype of inegraion sysem combining X2 and Y1. Under he X2 mehod he shareholder can receive a credi for par of he corporae ax paid on dividends, while he Y1 mehod admis o ax disribued profis a a lower rae han reained profis. I is ofen explained ha he double axaion of dividends is parially alleviaed a boh he shareholder and he company level. In 1990, his hybrid sysem was parially changed ino he presen form, i.e., he Y1 mehod was abandoned and he X2 mehod alone was reained o lighen he double axaion of dividends. For deails in relaive advanages in means of finance under he differen ax sysems and he differen raes (see Akinson and Sigliz (1980), pp ). Taxaion and Corporae Finance 6 Deb financing has one imporan advanage under he corporae income ax sysem in many counries. The ineres ha he company pays is a ax-deducible expense. Dividends and reained earnings are no. Thus he reurn o bondholders escapes axaion a he corporae level. Table 4 shows simple income saemens for firm U, which has no deb, and firm L, which has borrowed $1,000 a 8 percen. The ax bill of L is $28 less han ha of U. This is he ax shield provided by he deb of L. In effec he governmen pays 35 percen of he ineres 6 This secion draws heavily from Brealey and Myers (1996, Chaper 18). Lecures on Public Finance Par2_Chap4, 2015 version Page 12 of 47

13 expense of L. The oal income ha L can pay ou o is bondholders and sockholders increases by ha amoun. Tax shields can be valuable asses. Suppose ha he deb of L is fixed and permanen (ha is, he company commis o refinance is presen deb obligaions when hey maure and o keep rolling over is deb obligaions indefiniely). I looks forward o a permanen sream of cash flows of $28 per year. The risk of hese flows is likely o be less han he risk of he operaing asses of L. The ax shields depend only on he corporae ax rae 7 and on he abiliy of L o earn enough o cover ineres paymens. The corporae ax rae has been prey sable (i did fall from 46 o 34 percen afer he Tax Reform Ac of 1986, bu ha was he firs maerial change since he 1950s). And he abiliy of L o earn is ineres paymens mus be reasonably sure oherwise i could no have borrowed a 8 percen 8. Therefore we should discoun he ineres ax shields a a relaively low rae. Table 4 The ax deducibiliy of ineres increases he oal income ha can be paid ou o bondholders and sockholders. Income Saemen of Firm U Income Saemen of Firm L Earnings before ineres and axes $1,000 $1,000 Ineres paid o bondholders 0 80 Preax income 1, Tax a 35% Ne income o sockholders $650 $598 Toal income o boh bondholders and sockholders $0+650=$650 $80+598=$678 Ineres ax shield (.35 x ineres) $0 $28 Bu wha rae? The mos common assumpion is ha he risk of he ax shields is he same as ha of he ineres paymens generaing hem. Thus we discoun a 8 percen, he expeced rae of reurn demanded by invesors who are holding he firm s deb: 28 PV (ax shield) = = $ In effec he governmen iself assumes 35 percen of he $1,000 deb obligaion of L. Under hese assumpions, he presen value of he ax shield is independen of he reurn on he deb r D. I equals he corporae ax rae T c imes he amoun borrowed D: 7 Always use he marginal corporae ax rae, no he average rae. Average raes were ofen much less han ha because of acceleraed depreciaion and various oher adjusmens. 8 If he income of L does no cover ineres in some fuure year, he ax shield is no necessarily los. L can carry back he loss and receive a ax refund up o he amoun of axes paid in he previous 3 years. If L has a sring of losses, and hus no prior ax paymens ha can be refunded, hen losses can be carried forward and used o shield income in subsequen years. Lecures on Public Finance Par2_Chap4, 2015 version Page 13 of 47

14 Ineres paymen = reurn on deb amoun borrowed = r D D corporae ax rae expeced ineres paymen PV (ax shield) = Tc ( rd D) = = Tc D r D r D Of course, PV (ax shield) is less if he firm does no plan o borrow permanenly, or if i may no be able o use he ax shields in he fuure. Modigliani and Miller (MM) s heorem I amouns o saying ha he value of a pie does no depend on how i is sliced. The pie is he firm s asses, and he slices are he deb and equiy claims. If we hold he pie consan, hen a dollar more of deb means a dollar less of equiy value. Bu here is really a hird slice, he governmen s. Look a Table 4. I shows an expanded balance shee wih preax asse value on he lef and he value of he governmen s ax claim recognized as a liabiliy on he righ. MM would sill say ha he value of he pie in his case preax asse value is no changed by slicing. Bu anyhing he firm can do o reduce he size of he governmen s slice obviously makes sockholders beer off. One hing i can do is borrow money, which reduces is ax bill and, as we saw in Table 4, increases he cash flows o deb and equiy invesors. The afer-ax value of he firm (he sum of is deb and equiy values as shown in a normal marke value balance shee) goes up by PV (ax shield). MM and Taxes We have jus developed a version of MM s heorem I as correced by hem o reflec corporae income axes 9. The new proposiion is Value of firm = value if all - equiy - financed + PV (ax shield) In he special case of permanen deb, Value of firm = value if all - equiy - financed + T c D MM were no ha fanaical abou i. No one would expec he formula o apply a exreme deb raios. Bu ha does no explain why firms no only exis bu hrive wih no deb a all. I is hard o believe ha he managemen is simply missing he boa. Therefore we have argued ourselves ino a corner. There are jus wo ways ou: 1. Perhaps a fuller examinaion of corporae and personal axaion will uncover a ax disadvanage of corporae borrowing, offseing he presen value of he corporae ax 9 MM s original aricle Modigliani F. and M.H. Miller (1958), recognized ineres ax shields bu did no value hem properly. They pu hings righ in heir 1963 aricle Modigliani F. and M.H. Miller (1963). Lecures on Public Finance Par2_Chap4, 2015 version Page 14 of 47

15 shield. 2. Perhaps firms ha borrow incur oher coss bankrupcy coss, for example offseing he presen value of he ax shield. We will now explore hese wo escape roues. Corporae and Personal Taxes When personal axes are inroduce, he firm s objecive is no longer o minimize he corporae ax bill; he firm should ry o minimize he presen value of all axes paid on corporae income. All axes include personal axes paid by bondholders and sockholders. Figure 1 illusraes how corporae and personal axes are affeced by leverage. Depending on he firm s capial srucure, a dollar of operaing income will accrue o invesors eiher as deb ineres or equiy income (dividends or capial gains). Tha is, he dollar can go down eiher branch of Figure 1. Noice ha Figure 1 disinguishes beween T p, he personal ax rae on ineres, and T pe, he effecive personal rae on equiy income. The wo raes are equal if equiy income comes enirely as dividends. Bu T pe can be less han T p if equiy income comes as capial gains. Afer 2004, he op rae on ordinary income, including ineres and dividends, was 35 percen. The rae on realized capial gains was 15 percen 10. However, capial gains axes can be deferred unil shares are sold, so he op effecive capial gains rae can be less han 15 percen. The firm s objecive should be o arrange is capial srucure so as o maximize afer-ax income. You can see from Figure 1 ha corporae borrowing is beer if 1 Tp is more han 1 T ) (1 T ) ; oherwise, i is worse. The relaive ax advanage of deb over equiy is ( pe c 1 Tp Relaive ax advanage of deb = (1 T )(1 T ) pe c This suggess wo special cases. Firs, suppose all equiy income comes as dividends. Then deb and equiy income are axed a he same effecive personal rae. Bu wih T pe = T p, he relaive advanage depends only on he corporae rae: 10 Noe ha we are simplifying by ignoring corporae invesors, for example, banks, ha pay op raes of 35 percen. Of course, banks shield heir ineres income by paying ineres o lenders and deposiors. Lecures on Public Finance Par2_Chap4, 2015 version Page 15 of 47

16 Figure 1 The firm s capial srucure deermines wheher operaing income is paid ou as ineres or equiy income. Ineres is axed only a he personal level. Equiy income is axed a boh he corporae and he personal levels. However, T pe, he personal ax rae on equiy income, can be less han T p, he personal ax rae on ineres income. Operaing income $1.00 Paid ou as ineres Or paid ou as equiy income Corporae ax None T c Income afer corporae ax $1.00 $ 1.00 Tc Personal ax T T 1.00 T ) p pe ( c Income afer all axes 1.00 T ) ( p To bondholder 1.00 T c T = (1.00 T pe pe (1.00 T ) )(1.00 T ) To sockholder c c Relaive advanage = 1 Tp 1 = (1 T )(1 T ) 1 T pe c c In his case, we can forge abou personal axes. The ax advanage of corporae borrowing is exacly as MM calculaed i 11. They do no have o assume away personal axes. Their heory of deb and axes requires only ha deb and equiy be axed a he same rae. This case can happen only if T c' he corporae rae, is less han he personal rae T p and if T pe, he effecive rae on equiy income, is small. Meron Miller s Deb and Taxes How does capial srucure affec firm value invesors have differen ax raes? There is one model ha may help us hink hrough ha quesion. I was pu forward in Deb and 11 Of course, personal axes reduce he dollar amoun of corporae ineres ax shields, bu he appropriae discoun rae for cash flows afer personal ax is also lower. If invesors are willing o lend a a prospecive reurn before personal axes of r D, hen hey mus also be willing o accep a reurn afer personal axes of rd ( 1 Tp ), where T p is he marginal rae of personal ax. Thus we can compue he value afer personal axes of he ax shield on permanen deb: Tc ( rd D) (1 Tp ) PV(axshie ld) = = Tc D. This brings us back o our previous formula for firm rd (1 Tp ) value: Value of firm = value if all-equiy-financed + T c D. Lecures on Public Finance Par2_Chap4, 2015 version Page 16 of 47

17 Taxes Meron Miller s 1976 presidenial address o he American Finance Associaion 12. Miller was considering deb policy before he 1986 Tax Reform Ac. He sared by assuming ha all equiy income comes as unrealized capial gains and nobody pays any ax on equiy income; T pe is zero for all invesors. Bu he rae of ax on ineres depends on he invesor s ax bracke. Tax-exemp insiuions do no pay any ax on ineres; for hem is zero. A he oher exreme, millionaires paid ax a a rae of 50 percen on bond ineres; for hem T p was.50. Mos invesors fell somewhere beween hese wo exremes. Consider a simple world wih hese ax raes. Suppose ha companies are iniially financed enirely by equiy. If financial managers are on heir oes, his canno represen a sable siuaion. Think of i in erms of Figure 1. If every dollar goes down he equiy branch, here are no axes paid a he personal level (remember T = 0 ). Thus he financial manager need consider only corporae axes, which we know creae a srong incenive for corporae borrowing. As companies begin o borrow, some invesors have o be persuaded o hold corporae deb raher han common sock. There should be no problem in persuading ax-exemp invesors o hold deb. They do no pay any personal axes on bonds or socks. Thus, he iniial impac of borrowing is o save corporae axes and o leave personal axes unchanged. Bu as companies borrow more, hey need o persuade axpaying invesors o migrae from socks o bonds. Therefore hey have o offer an incenive in he form of a higher ineres rae on heir bonds. Companies can afford o incenive invesors o migrae as long as he corporae ax saving is greaer han he personal ax loss. Bu here is no way ha companies can give millionaires an incenive o hold heir bonds. The corporae ax saving canno compensae for he exra personal ax ha hose millionaires would need o pay. Thus he migraions sop when he corporae ax saving equals he personal ax loss. This poin occurs when T p, he personal ax rae of he migraing invesor, equals he corporae ax rae T c. Le us pu some numbers on his. The corporae ax rae T c was 46 percen. We coninue o assume ha T pe, he effecive rae of ax on equiy income, is zero for all invesors. In his case, companies will incenivize invesors wih ax raes below 46 percen o hold bonds. Bu here is nohing o be gained (or los) by persuading invesors wih ax raes equal o 46 percen o hold bonds. In he case of hese invesors $1 of operaing income will produce income afer all axes of $.54, regardless of wheher he dollar is ineres or equiy income: pe T p Income Remaining afer All Taxes Income paid ou as ineres 1 T p = 1.46 = $. 54 Income paid ou as equiy income ( 1 T pe )(1 Tc ) = (1 0)(1.46) = $ See Miller (1977). Lecures on Public Finance Par2_Chap4, 2015 version Page 17 of 47

18 In his equilibrium axes deermine he aggregae amoun of corporae deb bu no he amoun issued by any paricular firm. The deb-equiy raio for corporaions as a whole depends on he corporae ax rae and he funds available o individual invesors in he various ax brackes. If he corporae ax rae is increased, migraion sars again, leading o a higher deb-equiy raio for companies as a whole. If personal ax raes are increased, he migraion reverses, leading o a lower deb-equiy raio. If boh personal and corporae ax raes are increased by he same amoun 10 percenage poins, say here is no migraion and no change. Tha could explain why here was no subsanial increase in he deb-equiy raio when he corporae income ax rose drasically a he sar of World War II. Personal ax raes were simulaneously increased by abou he same amoun. The companies in our example ha firs sold bonds o ax-exemp invesors may have gained an advanage. Bu once he low-ax invesors have bough bonds and he migraions have sopped, no single firm can gain an advanage by borrowing more or suffer any penaly by borrowing less. Therefore here is no such hing as an opimal deb-equiy raio for any single firm. The marke is ineresed only in he oal amoun of deb. No single firm can influence ha. One final poin abou Miller s ax equilibrium: Because he assumes equiy reurns escape personal ax ( T = 0 ), invesors are willing o accep lower raes of reurn on low-risk pe common sock han on deb. Consider a safe (zero-bea) sock. The sandard capial asse pricing model would give an expeced reurn of r = r f, he risk-free ineres rae. Bu he invesor migraing from equiy o deb gives up r and earns r 1 T ), he afer-ax ineres f ( p rae. In equilibrium, he migraing invesor is conen wih eiher deb or equiy, so r = r f ( 1 Tp ). Moreover, ha invesor s T p equals he corporae rae T c. Therefore, r = r f 1 T ). If we accep Miller s argumen lock, sock, and barrel, he securiy marke ( c line should pass hrough he afer-ax risk-free ineres rae. The Boom Line on Deb and Taxes Miller s model was inended no as a deailed descripion of he Unied Saes ax sysem bu as a way of illusraing how corporae and personal axes could cancel ou and leave firm value independen of capial srucure. Neverheless, he model s predicions are plausible only if he effecive ax rae on equiy income is subsanially lower han ha on ineres, enough lower o offse he corporae ineres ax shield. Under oday s ax sysem, i s hard o see how Miller s model could work ou as he originally inended. Even if here were no ax advanage o borrowing before he 1986 ax low changes, here ough o be one now. The majoriy of financial managers and economiss believe our ax sysem favors corporae Lecures on Public Finance Par2_Chap4, 2015 version Page 18 of 47

19 borrowing. Bu i s easy o overesimae he advanage. Analyses which calculae he presen value of a safe, perpeual sream of corporae ineres ax shields, mus overesimae deb s ne value added. As Miller s paper shows, he aggregae supplies of corporae deb and equiy should adjus o minimize he sum of corporae and personal axes; a he resuling equilibrium he higher personal ax rae on deb income should parially offse he ax deducibiliy of ineres a he corporae level. We should also reconsider he assumpion ha he corporae ax shield on deb is a consan 35 percen regardless of he amoun borrowed. In pracice few firms can be sure hey will show a axable profi in he fuure. If a firm shows a loss and canno carry he loss back agains pas axes, is ineres ax shield mus be carried forward wih he hope of using i laer. The firm loses he ime value of money while i wais. If is difficulies are deep enough, he wai may be permanen and he ineres ax shield los forever. Noice also ha borrowing is no he only way o shield income agains ax. Firms have acceleraed wrie-offs for plan and equipmen. Invesmen in many inangible asses can be expensed immediaely. So can conribuions o he firm s pension fund. The more ha firms shield income in hese oher ways, he lower he expeced ax shield from borrowing 13. Thus corporae ax shields are worh more o some firms han o ohers. Firms wih pleny of nonineres ax shields and uncerain fuure prospecs should borrow less han consisenly profiable forms wih los of axable profis o shield. Firms wih large accumulaed ax-loss carry-forwards shouldn borrow a all. Why should such a firm incenivize axpaying invesors o hold deb when i can use ineres ax shields? We believe here is a moderae ax advanage o corporae borrowing, a leas for companies ha are reasonably sure hey can use he corporae ax shields. For companies ha do no expec o be able o use he corporae ax shields we believe here is a moderae ax disadvanage. Cos of Financial Disress Financial disress occurs when promises o crediors are broken or honored wih difficuly. Someimes financial disress leads o bankrupcy. Someimes i only means skaing on his ice. As we will see, financial disress is cosly. Invesors know ha levered firms may fall ino financial disress, and hey worry abou i. Tha worry is refleced in he curren marke value of he levered firm s securiies. Thus, he value of he firm can be broken down ino hree 13 For a discussion of he effec of hese oher ax shields on company borrowing, see DeAngelo and Masulis (1980). For some evidence on he average marginal ax rae of Unied Saes firms, see Cordes and Sheffrin (1981). Lecures on Public Finance Par2_Chap4, 2015 version Page 19 of 47

20 pars: Value of firm = Value if all - equiy - financed + PV (ax shield) - PV (coss of financial disress) The coss of financial disress depend on he probabiliy of disress and he magniude of coss encounered if disress occurs. Figure 2 shows how he rade-off beween he ax benefis and he coss of disress deermines opimal capial srucure. PV (ax shield) iniially increases as he firm borrows more. A moderae deb levels he probabiliy of financial disress is rivial, and so PV (cos of financial disress) is small and ax advanages dominae. Bu a some poin he probabiliy of financial disress increases rapidly wih addiional borrowing; he coss of disress begin o ake a subsanial bie ou of firm value. Also, if he firm can be sure of profiing from he corporae ax shield, he ax advanage of deb is likely o dwindle and evenually disappear. The heoreical opimum is reached when he presen value of ax savings due o addiional borrowing is jus offse by increases in he presen value of coss of disress. Coss of financial disress cover several specific iems. Now we idenify hese coss and ry o undersand wha causes hem. Figure 2 The value of he firm is equal o is value if all-equiy-financed plus PV (ax shield) minus PV (coss of financial disress). The manager should choose he deb raio ha maximizes firm value. Marke value PV (ax shield) PV (coss of financial disress) Value if all-equiy financed Opimal deb raio Deb raio Bankrupcy Coss Lecures on Public Finance Par2_Chap4, 2015 version Page 20 of 47

21 You rarely hear anyhing nice said abou corporae bankrupcy. Bu here is some good in almos everyhing. Corporae bankrupcies occur when sockholders exercise heir righ o defaul. Tha righ is valuable; when a firm ges ino rouble, limied liabiliy allows sockholders simply o walk away from i, leaving all is roubles o is crediors. The former crediors become he new sockholders, and he old sockholders are lef wih nohing. Financial Disress wihou Bankrupcy No every firm which ges ino rouble goes bankrup. As long as he firm can scrape up enough cash o pay he ineres on is deb, i may be able o pospone bankrupcy for many years. Evenually he firm may recover, pay off is deb, and escape bankrupcy alogeher. When a firm is in rouble, boh bondholders and sockholders wan i o recover, bu in oher respecs heir ineress may be in conflic. In imes of financial disress he securiy holders are like many poliical paries unied on generaliies bu hreaened by squabbling on any specific issue. Financial disress is cosly when hese conflics of ineres ge in he way of proper operaing, invesmen, and financing decisions. Sockholders are emped o forsake he usual objecive of maximizing he overall marke value of he firm and o pursue narrower self-ineres insead. They are emped o play games a he expense of heir crediors. We will now illusrae how such games can lead o coss of financial disress. Here is he Circular File Company s book balance shee: Circular File Company (Book Values) Ne working capial $20 $50 Bond ousanding Fixed asses Common sock Toal asses $100 $100 Toal liabiliies We will assume here are only one share and one bond ousanding. The sockholder is also he manager. The bondholder is somebody else. Here is is balance shee in marke values a clear case of financial disress, since he face value of Circular s deb ($50) exceeds he firm s oal marke value ($30): Circular File Company (Marke Values) Ne working capial $20 $25 Bond ousanding Fixed asses 10 5 Common sock Toal asses $30 $30 Toal liabiliies If he deb maured oday, Circular s owner would defaul, leaving he firm bankrup. Bu suppose ha he bond acually maures 1 year hence, ha here is enough cash for Circular o limp along for 1 year, and ha he bondholder canno call he quesion and force bankrupcy before hen. The 1-year grace period explains why he Circular share sill has value. Is owner is being Lecures on Public Finance Par2_Chap4, 2015 version Page 21 of 47

22 on a sroke of luck ha will rescue he firm, allowing i o pay off he deb wih somehing lef over. The be is a long sho he owner wins only if firm value increases from $30 o more han $ Bu he owner has a secre weapon: he conrols invesmen and operaing sraegy. Risk Shifing: The Firs Game Suppose ha Circular has $10 cash. The following invesmen opporuniy comes up: Now Inves $10 Possible Payoffs Nex Year $120 (10% probabiliy) $0 (90% probabiliy) This is a wild gamble and probably a lousy projec. Bu you can see why he owner would be emped o ake i anyway. Why no go for broke? Circular will probably go under anyway, and so he owner is essenially being wih he bondholder s money. Bu he owner ges mos of he loo if he projec pays off. Suppose ha he projec s NPV is -- $2 bu ha i is underaken anyway, hus depressing firm value by $2. Circular s new balance shee migh look like his: Circular File Company (Marke Values) Ne working capial $10 $20 Bond ousanding Fixed asses 18 8 Common sock Toal asses $28 $28 Toal liabiliies Firm value falls by $2, bu he owner is $3 ahead because he bond s value has fallen by $5 15. The $10 cash ha used o sand behind he bond has been replaced by a very risky asse worh only $8. Thus a game has been played a he expense of Circular s bondholder. The game illusraes he following general poin: Sockholders of levered firms gain when business risk increases. Financial managers who ac sricly in heir shareholders ineress (and agains he ineress of crediors) will favor risky projecs over safe ones. They may even ake risky projecs wih negaive NPVs. This warped sraegy for capial budgeing clearly is cosly o he firm and o he economy as a whole. Why do we associae he coss wih financial disress? Because he empaion o play is sronges when he odds of defaul are high. Exxon Mobil would never inves in our negaive-npv gamble. Is crediors are no vulnerable o his ype of game. Refusing o Conribue Equiy Capial: The Second Game 14 We are no concerned here wih how o work ou wheher $5 is a fair price for sockholders o pay for he be. 15 We are no calculaing his $5 drop. We are simply using i as a plausible assumpion. Lecures on Public Finance Par2_Chap4, 2015 version Page 22 of 47

23 We have seen how sockholders, acing in heir immediae, narrow self-ineres, may ake projecs which reduce he overall marke value of heir firm. These are errors of commission. Conflics of ineres may also lead o errors of omission. Assume ha Circular canno scrape up any cash, and herefore canno ake ha wild gamble. Insead a good opporuniy comes up: a relaively safe asse cosing $10 wih a presen value of $15 and NPV = +$5. This projec will no in iself rescue Circular, bu i is a sep in he righ direcion. We migh herefore expec Circular o issue $10 of new sock and o go ahead wih he invesmen. Suppose ha wo new shares are issued o he original owner for $10 cash. The projec is aken. The new balance shee migh look like his: Circular File Company (Marke Values) Ne working capial $20 $33 Bond ousanding Fixed asses Common sock Toal asses $45 $45 Toal liabiliies The oal value of he firm goes up by $15 ($10 of new capial and $5 NPV). Noice ha he Circular bond is no longer worh $25, bu $33. The bondholder receives a capial gain of $8 because he firm s asses include a new, safe asse worh $15. The probabiliy of defaul is less, and he payoff o he bondholder if defaul occurs is larger. The sockholder loses wha he bondholder gains. Equiy value goes up no by $15 bu by $15-$8 = $7. The owner pus in $10 of fresh equiy capial bu gains only $7 in marke value. Going ahead is in he firm s ineres bu no he owner s. Again, our example illusraes a general poin. If we hold business risk consan, any increase in firm value is shared among bondholders and sockholders. The value of any invesmen opporuniy o he firm s sockholders is reduced because projec benefis mus be shared wih bondholders. Thus i may no be in he sockholders self ineres o conribue fresh equiy capial even if ha means forgoing posiive-npv invesmen opporuniies. This problem heoreically affecs all levered firms, bu i is mos serious when firms land in financial disress. The greaer he probabiliy of defaul, he more bondholders have o gain from invesmens which increase firm value. And Three More Games, Briefly As wih oher games, he empaion o play he nex hree games is paricularly srong in financial disress. 1. Cash In and Run: Sockholders may be relucan o pu money ino a firm in financial disress, bu hey are happy o ake he money ou in he form of a cash dividend, for example. The marke value of he firm s sock goes down by less han he amoun of he Lecures on Public Finance Par2_Chap4, 2015 version Page 23 of 47

24 dividend paid, because he decline in firm value is shared wih crediors. This game is jus refusing o conribue equiy capial run in reverse. 2. Playing for Time: When he firm is in financial disress, crediors would like o salvage wha hey can by forcing he firm o sele up. Naurally, sockholders wan o delay his as long as hey can. There are various devious ways of doing his, for example, hrough accouning changes designed o conceal he rue exen of rouble, by encouraging false hopes of sponaneous recovery, or by cuing corners on mainenance, research and developmen, ec., in order o make his year s operaing performance look beer. 3. Bai and Swich: This game is no always played in financial disress, bu i is a quick way o ge ino disress. You sar wih a conservaive policy, issuing a limied amoun of relaively safe deb. Then you suddenly swich and issue a lo more. Tha makes all your deb risky, imposing a capial loss on he old bondholders. Their capial loss is he sockholders gain. Wha he Games Cos Why should anyone objec o hese games so long as hey are played by consening aduls? Because playing hem means poor decisions abou invesmens and operaions. These poor decisions are agency coss of borrowing. The more he firm borrows, he greaer he empaion o play he games (assuming he financial manager acs in he sockholders ineres). The increased odds of poor decisions in he fuure promp invesors o mark down he presen marke value of he firm. The fall in value comes ou of sockholders pockes. Poenial lenders, realizing ha games may be played a heir expense, proec hemselves by demanding beer erms. Therefore i is ulimaely in he sockholders ineres o avoid empaion. The easies way o do his is o limi borrowing o levels a which he firm s deb is safe or close o i. Bu suppose ha he ax advanages of deb spur he firm on o a high deb raio and a significan probabiliy of defaul or financial disress. Is here any way o convince poenial lenders ha games will no be played? The obvious answer is o give lenders veo power over poenially dangerous decisions. There we have he ulimae economic raionale for all ha fine prin backing up corporae deb. Deb conracs almos always limi dividends or equivalen ransfers of wealh o sockholders; he firm may no be allowed o pay ou more han i earns, for example. Addiional borrowing is almos always limied. For example, may companies are prevened by exising bond indenures from issuing any addiional long-erm deb unless heir raio of earnings o ineres charges exceeds RJR Nabisco bondholders migh have done beer if hey had effecive covenans o proec em agains drasic Lecures on Public Finance Par2_Chap4, 2015 version Page 24 of 47

25 Someimes firms are resriced from selling asses or making major invesmen oulays excep wih he lenders consen. The risks of playing for ime are reduced by specifying accouning procedures and by giving lenders access o he firm s books and is financial forecass. Of course, fine prin canno be a complee soluion for firms ha insis on issuing risky deb. The fine prin has is own coss; you have o spend money o save money. Obviously a complex deb conrac coss more o negoiae han a simple one. Aferward i coss he lender more o monior he firm s performance. Lenders anicipae monioring coss and demand compensaion in he form of higher ineres raes; hus he monioring coss anoher agency cos of deb are ulimaely paid by sockholders. Perhaps he mos severe coss of he fine prin sem from he consrains i places on operaing and invesmen decisions. For example, an aemp o preven he riskshifing game may also preven he firm from pursuing good invesmen opporuniies. A he minimum here are delays in clearing major invesmens wih lenders. In some cases lenders may veo high-risk invesmens even if ne presen value is posiive. Lenders can lose from risk shifing even when he firm s overall marke value increases. In fac, he lenders may ry o play a game of heir own, forcing he firm o say in cash or low-risk asses even if good projecs are forgone. Thus, deb conracs canno cover every possible manifesaion of he games we have jus discussed. Any aemp o do so would be hopelessly expensive and doomed o failure in any even. Human imaginaion is insufficien o conceive of all he possible hings ha could go wrong. We will always find surprises coming a us on dimensions we never hough o hink abou. We hope we have no lef he impression ha managers and sockholders always succumb o empaion unless resrained. Usually hey refrain volunarily, no only from a sense of fair play bu also on pragmaic grounds: A firm or individual ha makes a killing oday a he expense of a credior will be coldly received when he ime comes o borrow again. Aggressive game playing is done only by ou-and-ou crooks and by firms in exreme financial disress. Firms limi borrowing precisely because hey don wish o land in disress and be exposed o he empaion o play. The Trade-off Theory of Capial Srucure Financial managers ofen hink of he firm s deb-equiy decision as a rade-off beween ineres ax shields and he coss of financial disress. Of course, here is conroversy abou how valuable ineres ax shields are and wha kinds of financial rouble are mos hreaening, increases in financial leverage. Lecures on Public Finance Par2_Chap4, 2015 version Page 25 of 47

26 bu hese disagreemens are only variaions on a heme. Thus, Figure 2 illusraes he deb-equiy rade-off. This rade-off heory of capial srucure recognizes ha arge deb raios may vary from firm o firm. Companies wih safe, angible asses and pleny of axable income o shield ough o have high arge raios. Unprofiable companies wih risky, inangible asses ough o rely primarily on equiy financing. If here were no coss of adjusing capial srucure, hen each firm should always be a is arge deb raio. However, here are coss, and herefore delays, in adjusing o he opimum. Firms canno immediaely offse he random evens ha bump hem away from heir capial srucure arges, so we should see random differences in acual deb raios among firms having he same arge deb raio. All in all, his rade-off heory of capial srucure choice ells a comforing sory. Unlike MM s heory, which seemed o say ha firms should ake on as much deb as possible, i avoids exreme predicions and raionalizes moderae deb raios. Bu wha are he facs? Can he rade-off heory of capial srucure explain how companies acually behave? The answer is yes and no. On he yes side, he rade-off heory successfully explains many indusry differences in capial srucure. High-ech growh companies, for example, whose asses are risky and mosly inangible, normally use relaively lile deb. Airlines can and do borrow heavily because heir asses are angible and relaively safe 17. The rade-off heory also helps explain wha kinds of companies go privae in leveraged buy-ous (LBOs). LBOs are acquisiions of public companies by privae invesors who finance a large fracion of he purchase price wih deb. The arge companies for LBO akeovers are usually maure cash cow businesses wih esablished markes for heir producs bu lile in he way of high-npv growh opporuniies. Tha makes sense by he rade-off heory, because hese are exacly he kind of companies ha ough o have high deb raios. The rade-off heory also says ha companies saddled wih exra heavy deb oo much o pay down wih a couple of years inernally generaed cash should issue sock, consrain dividends, or sell off asses o raise cash o rebalance capial srucure. Here again, we can find pleny of confirming examples. When Texaco bough Gey Peroleum in January 1984, i borrowed $8 billion from a consorium of banks o help finance he acquisiion (The loan was arranged and paid over o Texaco wihin 2 weeks!). By he end of 1984, i had raised abou $1.8 billion o pay down his deb, mosly by selling asses and forgoing dividend 17 We are no suggesing ha all airline companies are safe; many are no. Bu aircraf can suppor deb where airlines canno. If Fly-by-Nigh Airlines fails, is planes reain heir value in anoher airline s operaions. There s a good secondary marke in used aircraf, so a loan secured by aircraf can be well proeced even if made o an airline flying on hin ice (and in he dark). Lecures on Public Finance Par2_Chap4, 2015 version Page 26 of 47

27 increases. Chrysler, when i emerged from near-bankrupcy in 1983, sold $432 million of new common sock o help regain a conservaive capial srucure 18. In 1991, afer a second brush wih bankrupcy, i again sold shares o replenish equiy, his ime for $350 million 19. On he no side, here are a few hings he rade-off heory canno explain. I canno explain why some of he mos successful companies hrive wih lile deb, hereby giving up valuable ineres ax shields. Think of Merck, i is basically all-equiy-financed. Graned, Merck s mos valuable asses are inangible, he fruis of is pharmaceuical research and developmen. We know ha inangible asses and conservaive capial srucures end o go ogeher. Bu Merck also has a very large corporae income ax bill ($1.4 billion in 1994) and he highes possible credi raing. I could borrow enough o save ens of millions of ax dollars wihou raising a whisker of concern abou possible financial disress 20. Merck illusraes an odd fac abou real-life capial srucures: Wihin an indusry, he mos profiable companies generally borrow he leas 21. Here he rade-off heory fails, for i predics exacly he reverse: Under he rade-off heory, high profis should mean more deb-servicing capaciy and more axable income o shield and should give a higher arge deb raio 22. A final poin on he no side for he rade-off heory: Deb raios in he early 1900s, when income ax raes were low (or zero), were jus as high as hose in he 1990s. Deb raios in oher indusrialized counries are equal o or higher han hose in he Unied Saes. Many of hese counries have impuaion ax sysems, which should eliminae he value of he ineres ax shields 23. None of his disproves he rade-off heory. As George Sigler emphasized, heories are no rejeced by circumsanial evidence; i akes a heory o bea a heory. So we now urn o a 18 Noe ha Chrysler issued sock afer i emerged from financial disress. I did no preven financial disress by raising equiy money when rouble loomed on is horizon. Why no? Refer back o Refusing o Conribue Equiy Capial: The Second Game or forward o he analysis of asymmeric informaion. 19 Chrysler simulaneously conribued $300 million of newly issued shares o is underfunded pension plans. 20 Research by Graham and Mackie-Mason has deeced a endency for axpaying firms o prefer deb financing. See J.R. Graham, Deb and he Marginal Tax Rae, Journal of Financial Economics, forhcoming; and J. Mackie-Mason, Do Taxes Affec Corporae Financing Decisions? Journal of Finance, 45: (December 1990). However, i seems clear ha public companies rarely make major shifs in deb raios jus because of axes. 21 For example, Carl Keser, in a sudy of he financing policies of firms in he Unied Saes and in Japan, found ha in each counry, high book profiabiliy was he mos saisically significan variable disinguishing low-from high-deb companies. See Capial and Ownership Srucure: A Comparison of Unied Saes and Japanese Manufacuring Corporaions, Financial Managemen, 15:5-16 (Spring 1986). 22 Here we mean deb as a fracion of he book or replacemen value of he company s asses. Profiable companies migh no borrow a greaer fracion of heir marke value. Higher profis imply higher marke value as well as sronger incenives o borrow. 23 We described he Ausralian impuaion ax sysem. Look again a Table 16-4, supposing ha an Ausralian corporaion pays $A10 of ineres. This reduces he corporae ax by $A3.30; i also reduces he ax credi aken by he shareholders by $A3.30. The final ax does no depend on wheher he corporaion or he shareholder borrows. You can check his by redrawing Figure 1 for he Ausralian sysem. The corporae ax rae T c will cancel ou. Since income afer all axes depends only on invesors ax raes, here is no special advanage o corporae borrowing. Lecures on Public Finance Par2_Chap4, 2015 version Page 27 of 47

28 compleely differen heory of financing. The Pecking Order of Financing Choices The pecking-order heory sars wih asymmeric informaion a fancy erm indicaing ha managers know more abou heir companies prospecs, risks, and values han do ouside invesors. Managers obviously know more han invesors. We can prove ha by observing sock price changes caused by announcemens by managers. When a company announces an increased regular dividend, sock price ypically rises, because invesors inerpre he increase as a sign of managemen s confidence in fuure earnings. In oher words, he dividend increase ransfers informaion from managers o invesors. This can happen only if managers know more in he firs place. Asymmeric informaion affecs he choice beween inernal and exernal financing and beween new issues of deb and equiy securiies. This leads o a pecking order, in which invesmen is financed firs wih inernal funds, reinvesed earnings primarily; hen by new issues of deb; and finally wih new issues of equiy. New equiy issues are a las resor when he company runs ou of deb capaciy, ha is, when he hrea of coss of financial disress brings regular insomnia o exising crediors and o he financial manager. Implicaions of he Pecking Order The pecking-order heory of corporae financing goes like his 24. 1) Firms prefer inernal finance. 2) They adap heir arge dividend payou raios o heir invesmen opporuniies, while rying o avoid sudden changes in dividends. 3) Sicky dividend policies, plus unpredicable flucuaions in profiabiliy and invesmen opporuniies, mean ha inernally generaed cash flow is someimes more han capial expendiures and oher imes less. If i is more, he firm pays off deb or invess in markeable securiies. If i is less, he firm firs draws down is cash balance or sells is markeable securiies. 4) If exernal finance is required, firms issue he safes securiy firs. Tha is, hey sar wih deb, hen possibly hybrid securiies such as converible bonds, hen perhaps equiy as a las resor. In his heory, here is no well-defined arge deb-equiy mix, because here are wo kinds of 24 The descripion is paraphrased form S.C. Myers, The Capial Srucure Puzzle, Journal of Finance, 39: (July 1984). For he mos par, his secion follows Myers s argumens. Lecures on Public Finance Par2_Chap4, 2015 version Page 28 of 47

29 equiy, inernal and exernal, one a he op of he pecking order and one a he boom. Each firm s observed deb raio reflecs is cumulaive requiremens for exernal finance. The pecking order explains why he mos profiable firms generally borrow less no because hey have low arge deb raios bu because hey don need ouside money. Less profiable firms issue deb because hey do no have inernal funds sufficien for heir capial invesmen program and because deb financing is firs on he pecking order of exernal financing. In he pecking-order heory, he aracion of ineres ax shields is assumed o be a second-order effec. Deb raios changes when here is an imbalance of inernal cash flow, ne of dividends, and real invesmen opporuniies. Highly profiable firms wih limied invesmen opporuniies work down o a low deb raio. Firms whose invesmen opporuniies ourun inernally generaed funds are driven o borrow more and more. This heory explains he inverse inraindusry relaionship beween profiabiliy and financial leverage. Suppose firms generally inves o keep up wih he growh of heir indusries. Then raes of invesmen will be similar wihin an indusry. Given sicky dividend payous, he leas profiable firms will have less inernal funds and will end up borrowing more. The pecking order seems o predic changes in many maure firms deb raios o a T. These companies deb raios increase when he firms have financial deficis and decline when hey have surpluses. If asymmeric informaion makes major equiy issues or reiremens 25 rare, his behavior is nearly ineviable. The pecking order is less successful in explaining inerindusry differences in deb raios. For example, deb raios end o be low in high-ech, high-growh indusries, even when he need for exernal capial is grea. There are also maure, sable indusries elecric uiliies, for example in which ample cash flow is no used o pay down deb. High dividend payou raios give he cash flow back o invesors insead. Financial Slack Oher hings equal, i s beer o be a he op of he pecking order han a he boom. Firms ha have worked down he pecking order and need exernal equiy may end up living wih excessive deb or passing by good invesmens because shares can be sold a wha managers consider a fair price. In oher words, financial slack is valuable. Having financial slack means having cash, markeable securiies, readily saleable real asses, and ready access o he deb markes or o bank financing. Ready access basically requires conservaive financing, so ha poenial 25 Companies wih low deb raios and surplus cash ofen repurchase sock, bu ordinary repurchases rarely cause maerial increases in deb raios. Lecures on Public Finance Par2_Chap4, 2015 version Page 29 of 47

30 lenders see he company s deb as a safe invesmen. In he long run, a company s value ress more on is capial invesmen and operaing decisions han on financing. Therefore, you wan o make sure your firm has sufficien financial slack, so ha financing is quickly available for good invesmens. Financial slack is mos valuable o firms wih pleny of posiive-npv growh opporuniies. Tha is anoher reason why growh companies usually aspire o conservaive capial srucures. Free Cash Flow and he Dark Side of Financial Slack 26 There is also a dark side o financial slack. Too much of i may encourage managers o ake i easy, expand heir perks, or empire-build wih cash ha should be paid back o sockholders. Michael Jensen has sressed he endency of managers wih ample free cash flow (or unnecessary financial slack) o plow oo much cash ino maure businesses or ill-advised acquisiions. The problem, Jensen says, is how o moivae managers o disgorge he cash raher han invesing i below he cos of capial or wasing i in organizaional inefficiencies. 27 If ha s he problem, hen maybe deb is an answer. Scheduled ineres and principal paymens are conracual obligaions of he firm. Deb forces he firm o pay ou cash. Perhaps he bes deb level would leave jus enough cash in he bank, afer deb service, o finance all posiive-npv projecs, wih no a penny lef over. 4.5 Taxaion and Invesmen A ypical analysis of he effec of axaion on capial sock is o consider a neoclassical firm ha is perfecly compeiive in produc and inpu markes. The firm adjuss is capial sock, perhaps subjec o adjusmen coss or compleely irreversibly. Given ha capial decisions affec profiabiliy over many years, he firm mus formulae expecaions abou fuure economic variables (e.g. inpu and oupu prices) and ax regimes (e.g. corporae ax raes and depreciaion rae). The axes considered for analysis include he corporae income ax, capial ax, propery ax, and resource ax. Specific ax incenives for capial may also be modeled, such as invesmen ax credis and allowances, acceleraed depreciaion, and ax holidays. The firm maximizes he value of is equiy or, alernaively, he presen value of cash flow, which is equal o is value of equiy and deb. The firm chooses he opimal pah of invesmen, aking ino accoun relevan economic and axes variables. The firm invess in 26 Some of he following is drawn from S.C. Myers, Sill Searching for Opimal Capial Srucure, Journal of Applied Corporae Finance, 6: 4-14 (Spring 1993). 27 M.C. Jensen, Agency Coss of Free Cash Flow, Corporae Finance and Takeovers, American Economic Review, 26: 323 (May 1986). Lecures on Public Finance Par2_Chap4, 2015 version Page 30 of 47

31 capial unil he value of marginal produc (less adjusmen coss) is equal o he user cos of capial. The user cos of capial can be hough of as he renal or lease price of capial, which is equal o depreciaion, risk, and financing coss, adjused for axes. The Cos of Depreciaion The cos of depreciaion is he reducion in he value of he asse over a given period. Suppose a firm purchases a machine for q 0. Over he period, he machine physically deerioraes by an amoun δ so ha only 1-δ unis of he machine are lef a he end of he period. Suppose ha idenical new machines can be sold for, in real erms, q 1 per uni a he end of he period. The reducion in he value of he machine over he period is equal o q 0 ( 1 δ ) q1 ( δ x) q1 where x ( q1 q0 ) q1 = which is he rae of real capial gains. The erm (δ-x) is he economic depreciaion rae, which is equal o he rae of physical wear and ear less he rae of real capial gains accused from holding an asse (evaluaed a he cos of replacemen). If here were perfec markes for all used asses, here would be no difficuly in calculaing rue economic depreciaion, bu used capial goods markes are nooriously imperfec. As a resul, he governmen has o employ he rule of humb depreciaion formulae. 1. sraigh-line depreciaion. 2. declining balance. 3. a fracion of he expendiure ha declines linearly over he lifeime (e.g. 10/55, 9/55, 8/55, 1/55 for an asse wih a life of en years) is allowed. 4. free depreciaion or invesmen ax credi. Such formulae do no ypically ensure rue economic depreciaion. Wheher hey are more or less generous depends in general on he relaionship beween he rue life and ha used for ax purposes. Wih a choice of depreciaion rae, financial policy and cos of capial (ne of depreciaion) can be relaed differenly from he previous discussion (see Akinson and Sigliz (1980), pp ). The Cos of Finance The cos of finance is he impued cos of borrowing money from financial markes. Given he absence of risk, he cos of finance (r) is equal o he ne-of-corporae-ax cos of issuing deb and equiy. Lecures on Public Finance Par2_Chap4, 2015 version Page 31 of 47

32 If ρ is he nominal opporuniy cos of invesing equiy in he firm and π is he rae of inflaion, he real cos of equiy finance is ρ-π. If i is he nominal bond ineres rae, which is deducible from corporae axable income a he corporae ax rae, c, hen he real cos of deb finance is herefore i( 1 c ) π. Using he formulaion of Auerbach (1979), he firm can be characerized as minimizing is cos of finance by choosing is opimal deb/equiy raio prior o making is invesmen decision. Le he proporion of invesmen o be financed by deb be β and 1-β by equiy, he cos of finance is equal o, ( ) + ( β ) ρ π r = R π = βi 1 (9) 1 c where R is he nominal cos of finance. The User Cos of Capial Taking ino accoun he depreciaion and financing coss, we can derive he user cos of capial which is he minimum reurn needed for invesmen o ake place. Suppose he cos of buying a capial good is $q per uni. If he governmen provides an invesmen ax credi which reduces corporae income ax paymens by an amoun equal o a percenage of gross invesmen ϕ, he cos of each capial good is reduced o $q(1-ϕ). In addiion, when a capial good is purchased, he governmen provides ax depreciaion deducions ha are of value o he firm. Le $Aq be he presen value of ax depreciaion allowances. The effecive cos of buying an asse is equal o $q(1-ϕ- ca). Under he assumpion ha he firm opimally chooses is capial sock, he user cos of capial can be easily derived. The reurn earned on he las dollar of invesmen equals gross income ne of corporae axes and is given by F/ k(1- c). The cos of holding capial is equal o he annual cos of depreciaion and financing coss muliplied by he effecive purchase price δ 1, where x is he rae of real capial gains and δ is he of capial, ( r + x) q( ϕ A) c depreciaion rae. For he opimal invesmen decision, he marginal reurn is equal o he marginal cos of holding capial, so his implies F 1 c c (10) k ( ) = ( r + δ x) q( 1 ϕ A) Lecures on Public Finance Par2_Chap4, 2015 version Page 32 of 47

33 Under he seady-sae condiions, he firm holds capial sock so ha he reurn per dollar of invesmen is consan over ime and his can be obained by rearranging he above expression F k r + δ x p = = q ϕ 1 c ( 1 A) c (11) The righ-hand side of (11) muliplied by q (he price of capial) is inerpreed as he user cos of capial for a firm ha invess in depreciable asses such as machinery and srucures. (11) Suggess he corporae ax sysem affecs he user cos of capial in he following ways. 1) The corporae ax reduces gross income and hus increases he user cos of capial. 2) The corporae ax reduces he effecive purchase price of capial hrough depreciaion allowances and invesmen ax credis. 3) The corporae ax reduces financing coss by allowing firms o wrie off nominal ineres expenses. Neuraliy of he Corporae Tax The corporae ax is neural wih respec o invesmen decisions of a firm under a ren or cash-flow ax, if invesmen is expensed (A=1), here is no invesmen ax credi (ϕ=0) and ineres is no deducible ( r = βi + (1 β ) ρ π ) q( r x) + δ which is independen of he corporae ax.. Tha is, he user cos of capial becomes The governmen usually violaes he neuraliy and gives special invesmen incenives such as acceleraed depreciaion allowances for manufacuring invesmen, invesmen ax credis for machinery, and lower corporae ax raes for specific indusries. The governmen may also provide ax holidays for firms. Noe, however, ha once he holiday is compleed, he firm has o pay corporae income axes, hus he governmen axes affec he cos of capial during he holidays as well. The Effecive Tax Rae on Capial To capure he effec of all he differen provisions of he corporae ax sysem on capial invesmen, we can use a kind of summary index o measure he effecive corporae ax rae on capial. The effecive ax rae is he amoun of ax paid as a percenage of he rae of reurn or capial Lecures on Public Finance Par2_Chap4, 2015 version Page 33 of 47

34 held a he margin. T rg rn = (12) r g Where r g and r n are he rae of reurn gross and ne axes. For example, in he case of depreciable capial, he gross rae of reurn on capial is equal o he expression for he income ne of economic depreciaion, ( x) case when all axes are zero, = βi + ( 1 β ) ρ π rae by using he formula (12). r n r g F k = δ. The ne rae of reurn on capial is he q. Then we can calculae he effecive ax Personal Taxaion and he Cos of Capial Personal ax may be an imporan elemen in assessing he cos of capial and effecive ax rae. To incorporae personal axes in he effecive ax rae, we need o ake accoun for personal axes on nominal ineres income ( pr), he accrual equivalen ax on nominal capial gains ( g) and he dividend ax ( pd). Afer personal axes are paid, invesors earn ineres income a he rae i(1- pr), capial gain income equals o ρ(1- g) and he dividend income equals o ρ(1- pd). Le α be he proporion of asses held as bonds, 1-α be ha of equiy, γ be he proporion of equiy income derived as capial gains and 1-γ be ha as dividends. Then he afer-ax rae of reurn on capial, afer correcing for personal axes and inflaion, can be expressed as, ( ) + ( 1 α ) ρ( θ ) π r = αi 1 (13) n 1 pr θ = γ + 1 γ ). Where θ = he average ax rae on equiy income ( g ( ) pd We can use (13) o calculae he effecive capial ax rae T defined in (12). This mehod is known as he King-Fulleron mehod (see King and Fulleron (1984) and Jorgenson and Landau (1993)). The inclusion of personal axes as par of he effecive ax rae measure raises he following difficulies. 1) Progressiviy of he ax rae schedule a he personal level. Lecures on Public Finance Par2_Chap4, 2015 version Page 34 of 47

35 This implies some invesors face lower ax raes on capial income han ohers. 2) Tax exempions for cerain form of savings. Some sources of savings are exemp from axaion. 3) Financial inermediaries Banks, insurance companies, muual funds, and oher financial insiuions have heir own special ax consideraions 4) Foreign Invesors Firms are owned no only by domesic invesors bu also by foreigners who are subjec o a counry s wihholding and income axes levied by he governmen where he invesor resides. 4.6 Empirical Sudies of Corporae Tax The empirical sudy of he effecs of axaion on firm behavior has been one of he mos acive areas of applied research in public finance (e.g. he influence of he corporae ax on finance decision). There are hree major approaches in he lieraure. (1) The Acceleraor Model: The acceleraor model is based on an assumpion ha relaive prices of labor and capial do no affec he demand for capial. Only oupu affecs invesmen, so ha impac of axes on invesmen would only be hrough he impac on aggregae demand. In funcional form, his model can be expressed as, ( Q Q ) I K K v (14) N = 1 = 1 where I = ne invesmen, K = capial sock, Q = oupu. A slighly modified version of his model, known as he flexible acceleraor model is given, I N = K K λ ( λ dq i (15) i 1 = v 1 ) i= 0 where dq = Q Q 1 For empirical modeling, we end o consider gross invesmen (i.e. ne invesmen (I N ) plus replacemen invesmen I R ). Tha is, Lecures on Public Finance Par2_Chap4, 2015 version Page 35 of 47

36 I N = I + I = K K R δk (16) Combining (24) and (25), he gross invesmen is given I 1 i ( 1 λ) dq i + δk 1 i= 0 = vλ For empirical applicaion, his model can furher be simplified as, I = + βq + γq 1 + δk 1 α (17) In case of Japan,he following model is esimaed by Zhu (1995). Period: 1970.I-1992.IV, Esimaion mehod: OLS, Sandard error in parenhesis. I = ( ) K R ( ) 2 = , ( ) 1 [ Q + Q + Q + Q ] I ( ) Dubins' h = (18) (2) The Neoclassical model: The neoclassical model assumes ha profi-maximizing firms will use capial and oher inpus in producion unil he marginal produc is equal o he price of he facor used in producion. The neoclassical model (e.g. Jorgenson (1963), Hall and Jorgenson (1967)) is based on an underlying producion funcion wih a given measure of subsiuabiliy of facors in producion. As i is assumed ha invesmen responds slowly o changes in oupu and he user cos of capial, an adjusmen is made so ha curren invesmen depends on boh curren and pas changes in capial sock. Under he neoclassical model, axes affec capial oupu as in he acceleraor model, as well as he user cos of capial. We can sae formally ha he firm is rying o maximize is ne revenue hrough ime while subjec o he consrains of (1) is echnology, embodied in he producion funcion and (2) he equaion of moion of he capial sock describing how he capial sock changes as invesmen occurs, given ha here is a consan rae of depreciaion of capial, δ. Lecures on Public Finance Par2_Chap4, 2015 version Page 36 of 47

37 The problem can be se in dynamic opimizaion. { p Q w L q I } r = e max V d (19) subjec o Q = F K, L ) (20) ( and K = I δk (21) where Q=oupu, p=price of oupu, w=wage, L=labor, q=price of capial, I=invesmen,δ=rae of depreciaion, K=capial sock, r=ineres rae. To solve his, we use he Hamilonian funcion as H { Q F K, L } + µ { I δk} = pq wl qi + λ ( ) (22) The firs order condiions are as follows. H Q H L H Z = 0 = 0 = 0 p + λ = 0 F = L µ = q w p ( µ e r ) = He K r F p K = q( r + δ ) q = c (23) where c=he user cos of capial Compared wih (20), for simpliciy, (31) ignores ax facors. Bu we should include hem in empirical modeling. Jorgenson (1963) assumes he Cobb-Douglas producion funcion, Q = AK α Lβ wih Lecures on Public Finance Par2_Chap4, 2015 version Page 37 of 47

38 α + β < 1 (decreasing reurns o scale). Wih his producion funcion, he marginal produc of capial F K = α( Q K), so (23) becomes F Q PQ p α = α p = c K * = K K c (24) Thus I * PQ = K = α c (25) Jorgenson furher assumes ha here are delivery lags for he new capial goods, wih he resul ha only a fixed fracion λ 0 of he goods ordered his period are acually delivered, a fracionλ 1, of he orders of his period are delivered nex periods, and so on. We can express his assumpion such ha I * * * = K = λ K + λ K + λ K + (26) Combining (25) wih (26), I PQ = λ0α c = α PQ λ i i= 0 c i PQ + λ1α c 1 PQ + λ2α c 2 + (27) In case of Japan, he following model is esimaed by Zhu (1995). Period: 1970.I-1992.IV, Esimaion mehod: OLS, Sandard error in parenhesis. I PQ = (0.0109) c PQ (0.0190) c ρ = , R 4 2 PQ (0.0178) c 1 PQ (0.0120) c = , DW = PQ (0.0214) c K (0.0016) 1 2 PQ (0.0219) c 3 (28) This is he basic funcional form of empirical model in which ax facors are incorporaed in he user cos of capial, c. There are subsanial objecions o his model. Among many criicisms, he following are Lecures on Public Finance Par2_Chap4, 2015 version Page 38 of 47

39 imporan. (a) The adjusmen process of he firm: Jorgenson s heoreical work implies ha he firm is always opimally adjused, ye in his empirical work, he imposes an ad hoc delivery lag. (b) Economeric objecions o he empirical work: criics argue ha he mehods used by Jorgenson will lead o biased and inconsisen esimaes because of auocorrelaion and lagged dependen variables. (c) The endogeneiy of oupu: a perfecly compeiive neoclassical firm chooses he oupu i wishes o supply. To have oupu as an explanaory variable is inconsisen wih he use of OLS esimaion. (d) The reamen of ax policy: axaion, depreciaion allowances, and ax credis affec he user cos of capial (c) and he desired capial sock (K * ). I is a mainained hypohesis ha a change in axaion has he same effec as a change in oher variables ha ener he user cos of capial (e.g. he ineres rae), bu i is an empirical hypohesis, no a sylized fac. A recen neoclassical approach is o use he invesmen demand funcion derived from he firm s maximizaion decision (he Euler equaion approach), which depends on fuure invesmen, he difference beween curren and fuure coss or prices of capial, and he reurn on capial. Taxes play an ineresing role by affecing boh curren and fuure variables. (3) The Q-heory Model: The Q model is based on he noion ha firms will inves in capial if he marke value of projecs is a leas as grea as he cos of purchasing capial. Q is measured as he raio of he marke value of a firm s equiy and deb liabiliies o is replacemen cos of capial. If Q is greaer han 1, hen he firm invess in capial, while if Q is less han 1, he firm will dives. In principle, he marke value of he firm embodies informaion used by invesors o evaluae discouned earnings of he firm. Moreover, as invesmen is deermined up o he poin whereby he marke value of he marginal uni of capial is equal o is purchase price, marginal Q would be he bes indicaor for invesmen decisions. However, he marginal Q is difficul o measure, since i requires one o measure he marke value of an incremenal projec decision. Insead, one mus measure he average Q, which is he oal marke value of he firm divided by he replacemen cos of is capial. In Q models, i is assumed ha invesmen is adjused wih a quadraic cos funcion. The Q variable is correced by reducing he replacemen cos of capial by he presen value of ax depreciaion allowances as well as correcing he marke value of equiy and deb by personal and corporae income axes ha influence he financing of capial (see Lecures on Public Finance Par2_Chap4, 2015 version Page 39 of 47

40 Summers (1981)). The real aracion of Q-heory is ha he original formulaion of Q in erms of sock marke value relaive o replacemen cos of capial (i.e. average Q) seems o offer a soluion o he problem surrounding he empirical esing of invesmen heories. I looks as if asse markes could be relied upon o diges all relevan expecaions and reflec hem in sock marke prices. Empirical work could use an observable marke variable o summarize all he informaion concerning expecaions formaion, marke condiions, and echnology which had divided previous formulaions of he invesmen equaion. Hayashi (1982) gives a rigorous analysis of he relaionship beween average and marginal Q and esablishes condiions under which marginal Q can be inferred from marke daa. He shows ha i is appropriae o proxy marginal by average Q under condiions of a puy-puy echnology, consan reurns o scale, and perfec compeiion. Edwards and Keen (1983) shows ha, when accoun is aken of differenial axaion, marginal Q, like he cos of capial, depends sensiively on he marginal source of finance. Formally, we can define he average Q such ha V A Q = (29) q K where V =he marke value of firm, q =price of capial, K =capial sock The marginal Q wih ax adjusmen is defined as Q M λ = ( 1 ψ A) q c where λ =shadow price of capial = he presen discouned value of addiional fuure profis resuling from an addiional uni of capial. ψ =a share of invesmen ax credi, A= depreciaion allowance, and c= corporae ax rae. Empirical model of Q-heory is, in general, given as follows. I M ln = α + βq + ε (30) K Zhu (1995) obains he following empirical esimae. Period: 1970.I-1992.IV, Esimaion mehod: OLS, Sandard error in parenhesis Lecures on Public Finance Par2_Chap4, 2015 version Page 40 of 47

41 I ln K R 2 = Q (0.0601) = , (0.1558) M DW = In pracice, empirical fi for (30) is no so good as expeced. I has empirical difficuly o capure all relevan informaion in a summary saisics of Q from marke daa. As shown in Hayashi (1982), acual marke condiions may no saisfy he heoreical assumpions of perfec compeiion, consan reurns o scale, and puy-puy echnology. Noe ha, in realiy, capial is no homogeneous, so ha each capial has is own Q, we need o consider muliple Q, no a single Q. Summary Table of pas empirical works is given in Table 4. Older sudies of invesmen behavior relied heavily on aggregae ime-series daa. Newer sudies use he firm-level microeconomic daa (afer in panel daa) wih much richer informaion. The overall conclusion from recen sudies is ha axes affec invesmen decisions, alhough he size of he effec is less clear. The firm-level sudies find somewha larger effecs bu here is sill considerable conroversy. Table 4 Hall and Jorgenson, 1967 Seleced invesmen sudies Sudy Period covered Mehodology Resuls Neoclassical; ime series of US manufacuring and non-manufacuring invesmens in srucures and equipmen. Elasiciy of capial o oupu varies from 0.04 o Summers, Q model wih ime-series invesmen Doubling invesmen ax credi raises invesmen 5.5% in firs year and 17.3% in he long run. Feldsein, Time-series sudy based on reurn over cos, effecive ax rae model. Chirinko and Use of six macroeconomic quarerly Eisner, 1983 models; srucures and machinery Poerba and Annual ime series of UK firms using Summers, 1983 a Q model wih personal and corporae ax raes. Chirinko, Similar o Feldsein sudy excep ha reurn on capial is lagged. Blundell, Bond, Devereux, and Schianarelli, 1992 Auerbach and Hasse, 1992 Devereux, Keen and Schianarelli, 1994 Bernsein and Shah, 1994 Elasiciy of invesmen o user cos is 0.52 Elasiciy of invesmen o reurn on capial is 0.58 and o oupu is Dividend axes impac on invesmen. Elasiciy of invesmen o reurn on capial is 0.17 and o oupu is Pooled firm-level daa using Q model Increase of 10% in marke value of equiy increases invesmen by 2.5% in he shor run Use of boh he Euler and Q model approaches and allowance for changes in ax raes Pooled firm-level daa using neoclassical and Q models allowing for ax losses Indusry-level daase for companies operaing in Pakisan based on a model of he user cos of capial. Tax policy plays a significan bu no necessarily sabilizing role in affecing invesmen. Allowing for ax losses does no improve measured impacs of ax sysem on invesmen. Shor-and long-run impacs allowing for various policy changes. Elasiciies are small bu invesmen ax credis have he larges impac per dollar of revenue loss. Lecures on Public Finance Par2_Chap4, 2015 version Page 41 of 47

42 Source: Minz (1996, p.164) Invesmen sudies require fuure effor o incorporae several issues. Firs, invesmen is modeled under he assumpion ha financing of capial is independen of invesmen (he Modigliani-Miller heorem). Financial and invesmen decisions may no be independen in pracice. Some firms may face a liquidiy consrain, so invesmen projecs may be adoped only if sufficien reained earnings are available. Some ypes of capial such as srucures and land may be more easily financed by deb ha can use hese capials as collaeral. Second, he incorporaion of expecaions abou he fuure has always plagued invesmen sudies. Alhough he Q and Euler equaion approaches have achieved some success a incorporaing he expecaions abou fuure variables in he models, hey sill rely on specific ad hoc assumpions such as quadraic adjusmen coss for invesmen. Third, governmen decision-making is assumed o be exogenous in mos invesmen models. Bu, in pracice, governmens reac o changes in he economy such as providing emporary invesmen ax credis during recessionary periods. If firms anicipae changes in governmen decisions, hen one should model no only invesmen behavior bu also governmen behavior o obain undersanding of invesmen and axes. Finally, he analysis of axaion requires good daa. The mos difficul problem afer faced by researchers is ha specific ax daa on firms, such as he composiion of depreciaion allowances, he use of ax loss carry-forward and carry-back provisions, and informaion on more inricae aspecs of ax law, probably resul in biased esimaes of coefficiens (perhaps owards smaller values) for ax variable erms. As seen above, here are considerable difficulies in making he ransiion from he heoreical model o he empirical model, including he specificaion of he producion funcion and of he lag srucure, he incorporaion of he ax variables, and he economeric problems. Lecures on Public Finance Par2_Chap4, 2015 version Page 42 of 47

43 Exercises 1. Brealy, Myers and Allen (2006, chap 18, Quiz 1) Compue he presen value of ineres ax shields generaed by hese hree deb issues. Consider corporae axes only. The marginal ax rae is T c =. 35. a. A $1,000, one-year loan a 8 percen. b. A five-year loan of $1,000 a 8 percen. Assume no principal is repaid unil mauriy. c. A $1,000 perpeuiy a 7 percen. 2. Brealy, Myers and Allen (2006, chap 18, Quiz 2) Here are book and marke value balance shees of he Unied Frypan Company (UF): Book Ne working capial $20 Deb $40 Long-erm asses 80 Equiy 60 $100 $100 Marke Ne working capial $20 Deb $40 Long-erm asses 140 Equiy 120 $160 $160 Assume ha MM s heory holds wih axes. There is no growh, and he $40 of deb is expeced o be permanen. Assume a 40 percen corporae ax rae. a. How much of he firm s value is accouned for by he deb-generaed ax shield? b. How much beer off will UF s shareholders be if he firm borrows $20 more and uses i o repurchase sock? 3. Brealy, Myers and Allen (2006, chap 18, Quiz 3) Wha is he relaive ax advanage of corporae deb if he corporae ax rae is T =. 35, he persona ax rae is T =. 35, bu all equiy income is received as capial gains and p escapes ax enirely ( T = 0 )? How does he relaive ax advanage change if he pe company decides o pay ou all equiy income as cash dividends ha are axed a 15 percen? 4. Brealy, Myers and Allen (2006, chap 18, Pracice Quesions 1) In he U.K., he op personal income ax rae is 40 percen. This rae applies o ineres and dividends. Capial gains are ax free, providing ha realized gains do no exceed an annual allowance of abou 8,000. All he individual sock holders of John Peel Group are in he op U.K. ax bracke, bu manage heir porfolios so ha realized capial gains never exceed heir annual allowances. Suppose ha he Group s effecive corporae ax rae is 30 percen. How does he sum of corporae and personal axes change if he Group: c Lecures on Public Finance Par2_Chap4, 2015 version Page 43 of 47

44 a. Operaes a a higher or lower deb raio? b. Increases or reduces cash dividend payou, holding capial invesmen and deb consan? Given your answers o (a) and (b), how would you advice he Group abou deb and dividend policy? Lecures on Public Finance Par2_Chap4, 2015 version Page 44 of 47

45 References Alman, E.A. (1983) Corporae Financial Disress: A Complee Guide o Predicing, Avoiding and Dealing wih Bankrupcy, John Wiley & Sons, New York. Archer, S.H. and C.A. D Ambrosio eds. (1983) The Theory of Business Finance, 3 rd ed., Macmillan. Akinson, A.B. and J.E. Sigliz (1980) Lecures on Public Economics, McGraw Hill Auerbach, A.J. (1979) Wealh Maximizaion and he Cos of Capial, Quarerly Journal of Economics, 93, Auerbach, A.J. (1983) Taxaion, Corporae Financial Policy and he Cos of Capial. Journal of Economic Lieraure,21: Auerbach, A.J. (1991) Rerospecive Capial Gains Taxaion, American Economic Review, 81, Auerbach, A.J. and K. Hasse (1992) Tax Policy and Business Fixed Invesmen in he Unied Saes, Journal of Public Economics, 47, Barclay, M.J. and C.W. Smih and R.L. Was (1995) The Deerminans of Corporae Leverage and Dividend Policies, Journal of Applied Corporae Finance, 7, pp Baskin, J. (1989) An Empirical Invesigaion of he Pecking Order Hypohesis, Financial Managemen, 18, pp Bernsein, J. and A. Shah (1994) Taxes and Producion: The Case of Pakisan, Inernaional Tax and Public Finance, 1, Blundell, R., S. Bond, M. Devereux and F. Schianarelli (1992) Invesmen and Tobin s Q: Evidence from Company Panel Daa, Journal of Economerics, 51, Bradford, D.F. (1980) The Economics of Tax Policy Toward Savings in The Governmen and Capial Formaion, edied by G. M. von Fursenberg. Cambridge, MA: Ballinger Publishing Company. Bradford, D.F. (1981) The Incidence and Allocaion Effecs of a Tax on Corporae Disribuions Journal of Public Economics, 15: pp Brealey, R, Myers S. and Allen F. (2006) Principles of Corporae Finance, 8h ed., McGraw Hill. Chirinko, R. (1987) Tax Ineffeciveness of Effecive Tax Raes on business Invesmen: A Criique of Feldsein s Fisher-Schulz Lecure, Journal of Public Economics, 32, Chirinko, R. and R. Eisner (1983) Tax Policy and Invesmen in Major U.S. Macroeconomeric Models, Journal of Public Economics, 20, Cordes J.J. and S.M. Sheffrin (1981) Taxaion and he Secoral Allocaion of Capial in he U.S., Naional Tax Journal, 34: Cummings, Harris, and Hasse (1994) Accouning Sandards, Informaion Flow, and Firm Invesmen Behavior., NBER Working Paper, No Naional Bureau of Economic Resech. DeAngelo, H. and R. Masulis (1980) Opimal Capial Srucure under Corporae Taxaion Journal of Financial Economics, 8, pp Devereux, M., M. Keen and F. Schianarelli (1994) Corporaion Tax Asymmeries and Invesmen: Evidence from U.K. Panel Daa, Journal of Public Economics, 53, Devereux, M.P. (ed) (1996) The Economics of Tax Policy, Oxford Universiy Press. Dixi, A.K. and R.S. Pindyck (1994) Invesmen Under Uncerainy, Princeon Universiy Press. Edwards, J.S.S. and M.J. Keen (1983) Taxaion, Invesmen and Marginal q, mimeo. Feldsein, M. (1982) Inflaion, Tax Rules and Invesmen: Some Economeric Evidence, Economerica, 50, Feldsein, M. and J. Flemming (1971) Tax Policy, Corporae Saving and Invesmen Behavior in Briain, Review of Economic Sudies, 38, Franks, J.R. and W.N. Torous (1989) An Empirical Analysis of U.S. Firms in Reorganizaion, Lecures on Public Finance Par2_Chap4, 2015 version Page 45 of 47

46 Journal of Finance, 44, pp Franks, J.R. and W.N. Torous (1994) How Shareholders and Crediors Fare in Workous and Chaper 11 Reorganizaions, Journal of Financial Economics, 35, pp Galai, D. and R.W. Masulis (1976) The Opion Pricing Model and he Risk Facor of Sock, Journal of Financial Economics, 3, pp Hall, R. and D. Jorgenson (1967) Tax Policy and Invesmen Behavior, American Economic Review, 57, Harberger, A.C. (1962) The Incidence of he Corporaion Income Tax Journal of Poliical Economy, 70, pp Harberger, A.C. (1966) Efficiency Effecs of Taxes on Income from Capial in Effecs of Corporaion Income Tax, edied by M. Krzyzaniak. Deroi: Wayne Sae Universiy Press. Harris, M. and A. Raviv (1991) The Theory of Opimal Capial Srucure, Journal of Finance, 48, pp Hayashi, F. (1982) Tobin s Marginal Q and Average Q: A Neoclassical Inerpreaion, Econom erica, 50, Hirshleifer, J. (1970) Invesmen, Ineres and Capial, Prenice-Hall Ishi, H. (1993) The Japanese Tax Sysem, 2 nd ed., Oxford Universiy Press. Jensen, M.C. and C.W. Jr. Smih (eds.) (1984) The Modern Theory of Corporae Finance, McGraw Hill. Jensen, M.C. and W.H. Meckling (1976) Theory of he Firm: Managerial Behavior, Agency Coss and Ownership Srucure, Journal of Financial Economics, 3, pp Jorgenson, D. (1963) Capial Theory and Invesmen Behavior, American Economic Review, 53, Jorgenson, D.W. and R. Landau (1993) Tax Reform and he Cos of Capial, The Brookings Insiuion. Kanninainen, V. and J. Södersen (1994a) The Imporance of Reporing Convenions for he Theory of Corporae Taxaion Uppsala Universiy Deparmen of Economics Working Paper No. 1994:5, Uppsala, Sweden: Uppsala Universiy. Kanninainen, V. and J. Södersen (1994b) Coss of Monioring and corporae Taxaion Journal of Public Economics, 55, pp King, M.A. (1974a) Taxaion and he Cos of Capial Review of Economic Sudies, 41, pp King, M.A. (1974b) Dividend Behaviour and he Theory of he Firm Economica, 41, pp King, M.A. (1977) Public Policy and he Corporaion, Chapman and Hall. King, M.A. and D. Fulleron (1984) The Taxaion of Income from Capial, The Universiy of Chicago Press. Miller, M.H. (1977) Deb and Taxes Journal of Finance, 32, pp Minz, J. (1986) The Corporaion Tax, in Devereux, M.P. (ed) The Economics of Tax Policy, Oxford Universiy Press. Modigliani F. and M.H. Miller (1958) The Cos of Capial, Corporaion Finance and he Theory of Invesmen, American Economic Review, 48: Modigliani, F. and M.H. Miller (1963) Corporae Income Taxes and he Cos of Capial: A Correcion, American Economic Review, 53, pp Modigliani, F. and M.H. Miller (1966) Some Esimaes of he Cos of Capial o he Elecric Uiliy Indusry, , American Economic Review, 56, pp Myers, S.C. (1977) Deerminans of Corporae Borrowing, Journal of Financial Economics, 5, pp Myers, S.C. (1984) The Capial Srucure Puzzle, Journal of Finance, 39, pp Myers, S.C. (1993) Sill Searching for Opimal Capial Srucure, Journal of Applied Corporae Finance, 6, pp Myers, S.C. and N.S. Majluf (1984) Corporae Financing and Invesmen Decisions When Lecures on Public Finance Par2_Chap4, 2015 version Page 46 of 47

47 Firms Have Informaion Invesors Do No Have, Journal of Financial Economics, 13, pp Myles, G.D. (1995) Public Economics, Cambridge Universiy Press. Nickell, S.J. (1978) The Invesmen Decisions of Firms, Cambridge Universiy Press. OECD (1987) Taxaion in Developed Counries, OECD. Poerba, J. and L. Summers (1983) Dividend Taxes, Corporae Invesmen and Q, Journal of Public Economics, 22, Poerba, J. and L. Summers (1985) The Economic Effecs of Dividend Taxaion., in E. Alman and M. Subrahmanyam (ed) Recen Advance in Corporae Finance. Precious, M. (1987) Raional Expecaions, Non-Marke Cleaning, and Invesmen Theory, Oxford Universiy Press. Sinn, H.W. (1985) Capial Income Taxaion and Resource Allocaion, Amserdam: Norh Holland. Translaion of Kapialeinkommenbeseuerung. Tübingen: Mohr. Sinn, H.W. (1991b) The Vanishing Harberger Triangle Journal of Public Economics, 45: Sigliz, J.E. (1973) Taxaion, Corporae Financial Policy, and he Cos of Capial Journal of Public Economics, 2, pp Summers, L. (1981) Taxaion and Corporae Invesmen: A Q-heory Approach, Brookings Papers on Economic Aciviy, vol. 1, Sǿrensen, P.B. (1994) Some Old and New Issues in he Theory of Corporae Income Taxaion EPRU Economic Sudies No.2, Copenhagen: Copenhagen Business School. Sǿrensen, P.B. (1995) Some Old and New Issues in he Theory of Corporae Income Taxaion Finanzarchiv, 52. Sǿrensen, P.B. (1999) Changing Views of he Corporae Income Tax in Slemrod J. (ed) Tax Policy in he Real World, Cambridge Universiy Press. Weiss, L.A. (1990) Bankrupcy Resoluion: Direc Coss and Violaion of Prioriy of Claims, Journal of Financial Economics, 27, pp Whie, M. (1989) The Corporae Bankrupcy Decision, Journal of Economic Perspecives, 3, pp Wruck, K.H. (1995) Financial Policy as a Caalys for Organizaional Change: Sealed Air s Leveraged Special Dividend, Journal of Applied Corporae Finance, 7, pp Zhu, B.H. (1995) Theory of Invesmen Funcion, Kyushu Universiy Press (in Japanese). Lecures on Public Finance Par2_Chap4, 2015 version Page 47 of 47