The Tax Reform Act of 1986 and Financial Leverage

THE TAX REFORM ACT OF 1986 AND FINANCIAL LEVERAGE

REVISITING THE MODIGLIANI-MILLER THEOREM

Courtney A. Hopley

February, 2003

Economics Major

Abstract

Despite the fact that the Tax Reform Act of 1986 was the most sweeping tax reform effort in recent US history, critics are concerned that the act could have worsened the distortion of corporate financing decisions by failing to address the unequal treatment of debt and equity finance. Two conflicting theories, the traditional theory of corporate finance and the Modigliani-Miller Theorem, make different predictions about the impact of this unequal treatment on debt utilization. The traditional theory states that the cost differential between debt and equity finance will be significant, whereas, the Modigliani-Miller Theorem states that the cost differential will be so small that it will not have an appreciable effect on capital structure decisions. This study supports the Modigliani-Miller contention, as the TRA 86 did not appear to have a significant effect on debt utilization in the aggregate. Moreover, it indicates that capital structure decisions are firm specific. Public policy and market forces influence each firm in a different way.

Keywords: (Tax, Leverage, Modigliani-Miller Theorem)

i