FIRM VALUATION, CORPORATE TAXES, AND DEFAULT RISK

SINCE MODIGLIANI AND MILLER [10] demonstrated that the values of firms in the same risk class are equal and are independent of the capital structure of the firm if the probability of default is zero and there are no taxes, a number of extensions of these results to the case of default risk have been given by Stiglitz [16], Smith [15], Baron [2, 3], and Hagen [5]. Conditions under which the values of firms in a risk class will be equal when there is default risk are given in [2]. While the relative values of firms in a risk class are equal, that common value of the firms is not independent of its financing, in general. If changes in the capital structure do not alter the available returns in the capital market, the capital market is complete and the value of the firm will be independent of its capital structure as indicated in [3]. This will be true if investors are able to create homemade leverage as considered by Stiglitz and Baron and thus duplicate any pattern of returns the firm can create by issuing bonds. The value of a firm is also independent of its capital structure in meanvariance models (for example [9, 12, 14]) and in an Arrow-Debreu model (see [8, 16]). Smith has considered the important issue of an investor's preferences for the financing of a firm with a variable scale in the presence of default risk and has demonstrated that investors are not in general indifferent to the financing of a firm with a variable scale in the presence of default risk when the capital market is incomplete. A synthesis of the results regarding the effects of capital structure is given in [3]. A corporate profits tax causes the value of a firm to depend on its debt-equity ratio even with a complete capital market. In the absence of default risk, Modigliani and Miller [11] determined that the value of a levered firm exceeds the value of an unlevered firm in the same risk class by the present value of the tax savings created by the debt in the capital structure. Kraus and Litzenberger [8] have obtained the same result in a contingent claims model. The objective of this paper is to explore the effect of corporate income taxes in the presence of default risk on the value of firms in the same risk class when the financing of the firm does not alter the available returns in the capital market. The analysis is in the spirit of the original works of Modigliani and Miller in the sense that the results are obtained from a partial equilibrium analysis. The analysis is based on a model that makes few restrictive assumptions regarding the probability distribution of earnings of firms or the preferences of inves