Government as the Firm's Third Financial Stakeholder: Impact on Capital Structure Discount Rates and Valuation

Abstract

We extend Myers’ Adjusted Present Value method (Myers, 1974) and modify Modigliani and Miller’s capital structure propositions (MM 1958, 1963) by adding government as the third major financial stakeholder. Stockholders, bondholders and government (federal and state) each possess a stake in the firm because of the potential to receive future cash flows. Given MM however, have major effects on relative stakeholder values and appropriate discount rates. Considering the three stakeholder model helps clarify the controversy over appropriate discount rates for each stakeholder’s cash flows, the social discount rate and tax structure. We further extend our models in an intertemporal framework that allows for reinvestment of earnings and firm growth. This extension provides clarification and has significant implications regarding firm valuation, capital investment and capital structure policy. We demonstrate that the corporate tax burden ultimately falls on shareowners and government is the beneficiary, whether the tax incidence is at corporate or individual level. However, corporate taxes may significantly impact domestic corporations’ abilities to compete in a global economy. In an intertemporal framework, shifting the tax burden from corporations to individuals and lowering the overall tax rates may increase government’s tax revenues through corporate growth despite a reduced proportional stake in firms.