Miller's Equilibrium, Shareholder Leverage Clienteles, and Optimal Capital Structure

Abstract

THE PURPOSE OF THIS paper is twofold. First, we examine the individual portfolio decisions when income from stocks and bonds is taxed at different rates. Second, a rationale for the existence of risky debt in the presence of leverage-related costs and differential personal income taxation is provided. Previous studies on capital structure with differential personal income taxation have ignored either the portfolio risk consideration and/or the possibility of losing personal and corporate interest tax shields due to insufficient taxable earnings (e.g., [8], [2], [3], [14], [13], [6], [7], [1], [9], [19], [20], [21], [23]). In Section I of this paper, both the portfolio risk consideration and the possibility of losing personal and corporate interest tax shields are explicitly introduced. This enables us to provide a rationale for the shareholder leverage clientele phenomenon within a mean-variance framework. We also demonstrate a non-corner solution for the optimal corporate capital structure in a tax environment similar to that of Miller's Debt and Taxes [14]. In Sections II and III of this paper, Miller's world is further modified to include risky debt and the attendant costs. We re-examine and synthesize recent studies on the theory of optimal capital structure which have appeared since the publication of Debt and Taxes (e.g., [4], [6], [7], [13], [19], [20]).