1 Ignoring costs of financial distress, what is the firm’s optimal capital structure if dividends and interest are taxed at the same personal rate – that is, tE = tD?

The firm should select the capital structure that gets the most cash into the hands of its investors. This is tantamount to selecting a capital structure that minimizes the total amount of taxes at both the corporate and personal levels.

As we have said, beginning with €1 of pre-tax corporate earnings, shareholders receive (1 − tc) × (1 − tE), and bondholders receive 1 – tD. We can see that if tE = tD, bondholders receive more than shareholders.

Thus, the firm should issue debt, not equity, in this situation. Intuitively, income is taxed twice – once at the corporate level and once at the personal level – if it is paid to shareholders. Conversely, income is taxed only at the personal level if it is paid to bondholders.

Note that the assumption of no personal taxes, which we used in the previous chapter, is a special case of the assumption that both interest and dividends are taxed at the same rate. Without personal taxes, the shareholders receive 1 – tc while the bondholders receive £1. Thus, as we stated in a previous section, firms should issue debt in a world without personal taxes.