Miller Channels Model

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

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

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

4. Recapitulation • Started with VU = VL • Corporate taxes • Financial distress

5. Value, VL Cost of Financial Distress VL = Vu + TCB Value of the firm Vu B

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

7. Against-the-Wall Mart Assets BV MV Liabilities BV MV Cash 200 200 LT bonds 300 ? Fixed Asset 400 0 Equity 300 ? Total 600 200 Total 600 200 What happens if the firm is liquidated today? LT Bonds = 200. Equity = 0.

8. Managers take bad risks Cost = $200 (all the firm’s cash) The gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Required return is 50% Expected CF from the gamble = $1000 x 0.10 + $0 = $100 NPV = - $200 + $100 / 1.5 = -$133 BAD PROJECT

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

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

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

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

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

14. Optimal Debt and Value Present value offinancial distress costs Value of firm (V) Present value of taxshield on debt VL=VU+TCB= Value of firm underMM with corporatetaxes and debt Maximumfirm value V=Actual value of firm VU=Value of firm with no debt 0 Debt (B) B* Optimal amount of debt

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

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

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

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

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

20. Debt channel Equity channel Corporate taxes TC Personal taxes TS TB 1-TB (1-TC)(1-TS) Channels $ of operating cash flows

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

22. Clienteles for the debt channel 1-TB > (1-TC)(1-TS) Low income investors (Low TB and TS ) Pension funds (TB = TS = 0) IRA's (low TB, TS, because deferred) Non profit organizations

23. Clienteles for the equity channel • 1-TB < (1-TC)(1-TS) • High income investors (high TB, low TS ) • Corporations (low TS on dividends)

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

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

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

27. Tax reform and leveraged buyouts in the late 1980's • Tax reform of 1986 • Raised TC, which favors bonds • Raised TS, which also favors bonds

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

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

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

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

32. Review item • In a world with corporate taxes, VL=VU+TCB. Why?

33. Answer: Present value of tax shield • Debt and other assets are perpetuities. • Let rB be the market rate for the bonds. • Interest payments of BrB each year generate a tax shield of TCBrB • Present value of this perpetuity is found by dividing by rB. Result is TCB.