Exam 13: Capital Structure and Distribution Policy

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In the no taxes model, the value of the levered firm equals the value of the unlevered firm, so the firm's value is $130 million. In the corporate taxes model, the value of the levered firm is the unlevered value plus the interest tax shield. The firm's levered value is: V_U + TD = $130 million + 0.40(50) = $150 million. So, the difference from using the corporate taxes model is $150 million - $130 million = $20 million.

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There is no definitive answer to this question, as different researchers have concluded different things. According to Gordon and Lintner, investors prefer dividends to capital gains because there is less uncertainty regarding dividends received now than there is for possible future capital gains. However, Modigliani and Miller called this the "bird-in-the-hand" fallacy and argued that the cost of common equity is independent of dividend policy. MM argued that what mattered was a firm's basic earning power and business risk and dividend policy was irrelevant. In addition, some have proposed that there is a tax preference reason for preferring capital gains over dividends. For years, dividends were taxed at high personal tax rates. As a result, some concluded that investors preferred capital gains which occurred in the future and were taxed at lower rates. In 2003, tax rates on dividends were lowered to the capital gains tax rate but the deferment of taxes is still valid.