Corporate taxes, capital structure, and valuation: Combining Modigliani/Miller and Miles/Ezzell

Abstract

The valuation of a firm with discounted cash flow (DCF) approaches requires assumptions about the firm’s financing strategy. The approaches of Modigliani and Miller and Miles and Ezzell assume that either a passive debt management with predetermined debt levels or active debt management with capital structure targets is applied. Over the last decades, various extensions of these approaches have been developed to allow for a more realistic depiction of financial decision making. However, recent empirical analyses indicate that current theories still have limited power to explain large variances in capital structure across time. We provide an alternative explanation for the empirical observation by assuming that firms combine both capital structure targets and predetermined debt within future periods, and we show how to value a firm given such a partially active debt management. The approaches of Modigliani and Miller and Miles and Ezzell are embedded into a common valuation framework, with the familiar valuation formulas shown as special cases. In a simulation analysis, we illustrate that the textbook valuation formulas may produce considerable valuation errors if a firm applies a partially active debt management.