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THEJOURNALOFFINANCE.VOL.XXXII.NO.2.MAY1977TheJournalofFINANCEVOL.XXXIIMAY1977No.2DEBTANDTAXES*MERTONH.MILLER**THESOMEWHATHETERODOXVIEWSaboutdebtandtaxesthatwillbepresentedherehaveevolvedoverthelastfewyearsinthecourseofcountlessdiscussionswithseveralofmypresentandformercolleaguesintheFinancegroupatChicago-FischerBlack,RobertHamada,RogerIbbotson,MyronScholesandespeciallyEugeneFama.CharlesUptonandJosephWilliamshavealsobeenparticularlyhelpfultomerecentlyinclarifyingthemainissues.’Mylong-timefriendandcollaborator,FrancoModigliani,isabsolvedfromanyblamefortheviewstofollownotbecauseIthinkhewouldrejectthem,butbecausehehasbeenabsorbedinpreparinghisPresidentialAddresstotheAmericanEconomicAssociationatthissameConvention.Thiscoincidenceneatlysymbolizesthecontributionwetriedtomakeinourfirstjointpaperofnearlytwentyyearsago;namelytobringtobearonproblemsofcorporatefinancesomeofthestandardtoolsofeconomics,especiallytheanalysisofcompetitivemarketequilibrium.Priortothattime,theacademicdiscussioninfinancewasfocusedprimarilyontheempiricalissueofwhatthemarketreal&capitalized.*Didthemarketcapitalizeafirm’sdividendsoritsearningsorsomeweightedcombinationofthetwo?Diditcapitalizenetearningsornetoperatingearningsorsomethinginbetween?Theanswerstothesequestionsandtorelatedquestionsaboutthebehaviorofinterestratesweresupposedtoprovideabasisforchoosinganoptimalcapitalstructureforthefirminaframeworkanalogoustotheeconomist’smodelofdiscriminatingmonopsony.Wecameattheproblemfromtheotherdirectionbyfirsttryingtoestablishthepropositionsaboutvaluationimpliedbytheeconomist’sbasicworkingassumptionsofrationalbehaviorandperfectmarkets.Andwewereabletoprovethatwhenthefullrangeofopportunitiesavailabletofirmsandinvestorsundersuchconditions*PresidentialAddress,AnnualMeetingoftheAmericanFinanceAssociation,AtlanticCity,N.J.,**UniversityofChicago.I.Morethanperfunctorythanksarealsoduetothemanyotherswhocommented,sometimeswithconsiderableheat,ontheearlierversionsofthistalk:RayBall,MarshallBlume,GeorgeFoster,NicholasGonedes,DavidGreen,E.HanKim,RobertKrainer,KatherineMiller,CharlesNelson,HansStoll,JeroldWarner,WilliamWecker,RomanWeil,andJ.FredWeston.Iamespeciallyindebted(nopunintended)toFischerBlack.2.Toavoidreopeningoldwounds,nonameswillbementionedhere.Referencescanbesuppliedonrequest,however.September17,1976.26I262TheJournalofFitiaticearetakenintoaccount,thefollowingsimpleprinciplewouldapply:inequilibrium,themarketvalueofanyfirmmustbeindependentofitscapitalstructure.Thearbitrageproofofthispropositioncannowbefoundinvirtuallyeverytextbookinfinance,followedalmostinvariably,however,byawarningtothestudentagainsttakingitseriously.Somedismissitwiththestatementthatfirmsandinvestorscan’tordon’tbehavethatway.I’llreturntothatcomplaintlaterinthistalk.Othersobjectthattheinvariancepropositionwasderivedforaworldwithnotaxes,andthatworld,alas,isnotours.Inourworld,theypointout,thevalueofthefirmcanbeincreasedbytheuseofdebtsinceinterestpaymentscanbedeductedfromtaxablecorporateincome.Toreapmoreofthesegains,however,thestockholdersmustincurincreasingrisksofbankruptcyandthecosts,directandindirect,offallingintothatunhappystate.Theyconcludethatthebalancingofthesebankruptcycostsagainstthetaxgainsofdebtfinancegivesrisetoanoptimalcapitalstructure,justasthetraditionalviewhasalwaysmaintained,thoughforsomewhatdifferentreasons.ItisthisnewandcurrentlyfashionableversionoftheoptimalcapitalstructurethatIproposetochallengehere.Iwillarguethateveninaworldinwhichinterestpaymentsarefullydeductibleincomputingcorporateincometaxes,thevalueofthefirm,inequilibriumwillstillbeindependentofitscapitalstructure.I.BANKRUPTCYCOSTSINPERSPECTIVELetmefirstexplainwhereIthinkthenewoptimumcapitalstructuremodelgoeswrong.ItisnotthatIbelievetheretobenodeadweightcostsattachingtotheuseofdebtfinance.Bankruptcycostsandagencycostsdoindeedexistaswasdutifullynotedatseveralpointsintheoriginal1958article[28,seeespeciallyfootnote18andp.2931.Itisjustthatthesecosts,byanysensiblereckoning,seemdispropor-tionatelysmallrelativetothetaxsavingstheyaresupposedlybalancing.Thetaxsavings,afterall,areconventionallytakenasbeingontheorderof50centsforeachdollarofpermanentdebti~sued.~Thefigureoneusuallyhearsasanestimateofbankruptcycostsis20percentofthevalueoftheestate;andifthiswerethetrueorderofmagnitudeforsuchcosts,theywouldhavetobetakenveryseriouslyindeedasapossiblecounterweight.ButwhenthatfigureistracedbacktoitssourceinthepaperbyBaxter[5](andthesubsequentandseeminglyconfir-matorystudiesofStanleyandGirth[36]andVanHorne[39]),itturnsouttorefermainlytothebankruptciesofindividuals,withasprinklingofsmallbusinesses,mostlyproprietorshipsandtypicallyundergoingliquidationratherthanreorganiza-tion.TheonlystudyIknowthatdealswiththecostsofbankruptcyandreorganiza-tionforlarge,publicy-heldcorporationsisthatofJeroldWarner[40].Warner3.See,amongothers,ModiglianiandMiller[27].The50percentfigure-actually48percentunderpresentFederallawplussomeadditionalstateincometaxesformostfirms-isanupperboundthatassumesthefirmalwayshasenoughincometoutilizethetaxshieldontheinterest.