The Tax Reform Act of The Tax Reform Act of 19861986

Revisiting the Revisiting the Modigliani-Miller Modigliani-Miller

TheoremTheorem

Courtney HopleyCourtney Hopley

May 7, 2003May 7, 2003

The Tax Reform Act of 1986The Tax Reform Act of 1986

Comprehensive tax reform effortComprehensive tax reform effort

Eliminated many corporate tax Eliminated many corporate tax deductionsdeductions

Failure to address unequal tax Failure to address unequal tax treatment of debt and equity treatment of debt and equity financefinance

The QuestionThe Question

Has the TRA 86 had a Has the TRA 86 had a significant long-term effect on significant long-term effect on corporate debt-utilization?corporate debt-utilization?

Economic TheoryEconomic Theory

Debt vs. Equity FinanceDebt vs. Equity Finance

How does a firm determine its How does a firm determine its optimal capital structure?optimal capital structure?

The Traditional TheoryThe Traditional Theory

Each firm has an optimal Each firm has an optimal capital structurecapital structure

Tax effect is significantTax effect is significant

The Traditional TheoryThe Traditional Theory

The Modigliani-Miller The Modigliani-Miller TheoremTheorem

Firm valuation is independent Firm valuation is independent of capital structure compositionof capital structure composition

Tax effect is extremely smallTax effect is extremely small

No advantage from increasing No advantage from increasing debt utilizationdebt utilization

The DataThe Data

Twenty-six corporations from Twenty-six corporations from 1981 to 19991981 to 1999

Cross-section of American Cross-section of American industriesindustries

The VariablesThe Variables

Dependent Variable-Dependent Variable-Debt-to-Equity Ratio = Debt-to-Equity Ratio = Long Term DebtLong Term Debt

Stockholders’ Stockholders’ EquityEquity

Explanatory Variables-Explanatory Variables-1. Tax Policy Change Dummy1. Tax Policy Change Dummy2. Event Variable2. Event Variable3. Moody’s Aaa Bond Rating3. Moody’s Aaa Bond Rating

MethodMethod

Pooled time-series cross-Pooled time-series cross-sectional methodsectional method

TSCS REG Procedure in SASTSCS REG Procedure in SAS

Aggregate ResultsAggregate Results

DE = 0.556 – 0.075 T + 0.123 E + 0.0044 A + DE = 0.556 – 0.075 T + 0.123 E + 0.0044 A + µµ11

(1.63) (-0.46) (15.30) (0.13)(1.63) (-0.46) (15.30) (0.13)

Total R-Square = 0.0024Total R-Square = 0.0024

T= TaxT= Tax

E= EventE= Event

A= Aaa A= Aaa

Firm-by-Firm AnalysisFirm-by-Firm Analysis

Considerable variation among Considerable variation among firms as to significant firms as to significant variablesvariables

Tax variable is statistically Tax variable is statistically significant for a number of significant for a number of firmsfirms

ConclusionsConclusions

On average, the TRA 86 did On average, the TRA 86 did not increase debt-to-equity not increase debt-to-equity ratios significantlyratios significantly

Tax effect is small for typical Tax effect is small for typical firmfirm

Theory ConclusionTheory Conclusion

ConclusionsConclusions

Different firms weigh different factors Different firms weigh different factors more heavily in capital structure more heavily in capital structure decisionsdecisions

Each firm affected differently by public Each firm affected differently by public policypolicy

Belonging to an industry is only a partial Belonging to an industry is only a partial determinant of significant factors determinant of significant factors