FUNDAÇÃO GETÚLIO VARGAS

ESCOLA BRASILEIRA DE ADMINISTRAÇÃO

PÚBLICA E DE EMPRESAS

CÉSAR SILVA GOMES

MILLER’S MODEL ON PERSONAL TAXES AND THE

BRAZILIAN TRIBUTARY STRUCTURE

Rio de Janeiro

2010
 César Silva Gomes

Miller’s Model on Personal Taxes And The Brazilian

Tributary Structure

Monografia apresentada ao curso de

Administração da Escola Brasileira de
Administração Pública e de Empresas
da Fundação Getúlio Vargas do Rio de
Janeiro como requisito à obtenção do
título de Bacharel em Administração.
Orientado pelo Prof. Rogério Sobreira.

Rio de Janeiro
2010
 César Silva Gomes

Miller’s Model on Personal Taxes And The Brazilian

Tributary Structure

_________________________________________

Rogério Sobreira

_________________________________________

Membro 2

_________________________________________

Membro 3
 ABSTRACT

This study shows how the Miller’s Model on Personal Taxes may work in the

Brazilian tributary legislation. Through this work we see the basics of capital structure

theories and how Merton Miller developed his theories to the personal taxes model.

In order to help assess Miller’s model to Brazil this work studies the Brazilian

legislation mainly regarding the income taxes. Following Miller’s model there is an

emphasis on corporate income tax, personal tax on bonds and personal income tax

on stocks. Also it is shown how companies in Brazil may benefit from the interest

over equity, a form of paying dividends to a certain limit (the TJLP) that can be

deducted from the corporate income tax.

In this work there is shown the income tax rates to form Miller’s Model on Personal

Taxes in Brazil. According to the Brazilian legislation these rates are 34% for

corporate income taxes, 15% for personal income tax on stockss and it may vary

between 15% and 22.5% for personal income tax on bonds, depending on the

duration of the bond.

The conclusion of this paper is that according to Miller’s model and the Brazilian

legislation, companies in Brazil have an incentive to issue debt indefinitely, as this

would increase its value.

Key words: Capital Structure; Modigliani & Miller; Miller’s Model; Personal Taxes;

Brazilian Taxes; Brazil; Interest on Equity; Dividends; Income Taxes.

JEL Classification: G32

 LIST OF FIGURES

Figure 1 - Value of the leveraged firm as a function of bonds issued.........................12

Figure 2 - Cost of as a function of bonds issued.........................................................13

Figure 3 - Value of the leveraged firm as a function of the Corporate Income Tax

Rate.............................................................................................................................15

Figure 4 - Value of the leveraged firm as a function of the Personal Income Tax on

Stocks..........................................................................................................................16

Figure 5 - Value of the leveraged firm as a function of the Personal Income Tax on

Bonds..........................................................................................................................17

Figure 6 - Gain of leverage as a function of the amount of Bonds issued (each line

represents a different tax bracket on the Personal Income Tax on Bonds)...............25

Figure 6 - Gain of leverage as a function of the amount of Bonds

issued (each line represents a different tax bracket on the Personal

Income Tax on Bonds)

LIST OF FIGURES

Table 1 - Benefits for the use of Interest on Equity.....................................................22

Table 2 - Personal Income Tax Rate on Bonds..........................................................23

Table 2 - Personal Income Tax Rate on Bonds
LIST OF ABREVIATIONS

B - Value of the firm’s bonds

Bl - Value of the leveraged firm’s bonds

r0 - Return of the firm

rb - The interest rate of the firm’s bonds

rs - The expected return on shares

S - Value of the firm’s shares

Tb - Personal income tax rate on bonds

Tc - Corporate income tax rate

Ts - Personal income tax rate on shares

Vl - Total value of the leveraged firm

Vu - Total value of the unleveraged firm

 SUMMARY

1 - INTRODUCTION......................................................................................................3

2 - METHODOLOGY.....................................................................................................3

3 - CAPITAL STRUCTURE REVISITED.......................................................................3

3.1 - MODIGLIANI & MILLER....................................................................................3

3.1.1 - CORPORATE TAXES ON MODIGLIANI & MILLER..................................3

3.1.2 - MILLER’S MODEL ON PERSONAL TAXES..............................................3

4 - BRAZILIAN TRIBUTES............................................................................................3

4.1 – CORPORATE INCOME TAX...........................................................................3

4.2 - PERSONAL INCOME TAX ON EQUITY..........................................................3

4.3 - PERSONAL INCOME TAX ON DEBT..............................................................3

5 - MILLER'S MODEL AND BRAZILIAN TAX STRUCTURE.......................................3

6 - FINAL CONCLUSIONS............................................................................................3

REFERENCES..............................................................................................................3
REFERENCES
 10

1 - INTRODUCTION

One of the important questions that the finance theories have been trying to answer

through the years is which is the best capital structure for each company. Nowadays

there are infinite ways to structure the capital of a firm, by different equity-to-debt

ratios, or by the use of different ways to obtain capital, like preferred stocks,

convertible bonds among others (ROSS ET AL. 2002).

Since back in the late 50’s Modigliani & Miller tried to solve this matter with their

proposition I and II in their first paper (MODIGLIANI & MILLER 1958). In their second

paper, they published a correction regarding the role of tax rates and its influence on

capital structure (MODIGLIANI & MILLER 1963).

Later on, Miller published another paper with his model on personal taxes, where he

showed the effect of personal taxes on the capital structure of a firm. Miller divided

the effect of corporate income taxes, personal income taxes on shares and personal

income taxes on bonds, to evaluate how they influence in the value of a firm when

deciding to issue bonds or shares.

Although these theories are well known in finance, they were made for the American

tax reality, and are not straightly adapted to other countries with different legislation

regarding income taxes.

In Brazil, there are some differences that must be considered. Through the research

to be made on this study, these differences are to be found and used in the

proposition of an adaptation of Miller’s model to Brazil.

The main relevance of the study is to help understand the capital structure of

Brazilian firms, and also help the companies improve their value by a better

understanding on how their capital structure may or may not influence on their total

market value. Also the adaptation of such a worldwide important theory to Brazilian
 11

taxes should help finance students located in Brazil to learn, evaluate and discuss

Miller’s Model.

The objective of this study is then to answer the question on how would the Miller’s

Model on Personal Taxes adapt to the current Brazilian legislation on taxes. To

answer this question first we need to pass through some other smaller problems,

which are, how the Brazilian legislation deals with the payment of dividends, which is

the corporate income tax rate, which is the personal income tax rate on shares and

on bonds. It is also important to find difference in the ways that these taxes may be

applied in Brazil, when compared to the American reality in which the original

theories were constructed.

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2 - METHODOLOGY

To adapt the Miller Model on Personal Taxes (MILLER 1976) to the Brazilian tributary

reality there is going to be used a bibliographic research on the capital structure

papers of Modigliani & Miller (including here Miller’s paper on personal taxes) and on

the Brazilian Legislation.

On the capital structure papers of Modigliani & Miller there will be analyzed the major

points in which the tax legislations may cause a difference when trying to adapt the

capital structure theories to other countries realities, such as which taxes affect the

models to be studied here, and which differences in the legislations may change, and

how they may change, the model.

On the Brazilian legislation there will be a search for laws that impact the tributes that

may interfere with Miller’s Model on Personal Taxes, as seen in the previous

paragraph. There will be conduct a search through the Brazilian IRS to find the laws

that present relevance to the problem, such as laws on corporate income taxes,

personal income taxes on bonds, personal income taxes on shares, and other

differences to the model that may be relevant to the capital structure of the firms.
 13

3 - CAPITAL STRUCTURE REVISITED

Before dealing with the analysis needed to adapt the Modigliani & Miller theories to

the Brazilian tributary reality we have to understand how these theories deal with, the

capital structure of a firm.

The capital structure of a firm is how it finances its assets. It can be done though

equity (or stocks) debt (like bonds and leases) or some hybrid securities (ROSS ET

AL. 2002). These hybrid securities are not going to be discussed here because

although they are largely used in the real market, the analyses get too complex and

don’t bring deepness into the study.

The importance of studying the capital structures of the firms is to try to answer the

question if the debt-to-equity ratio can add value to a company and its stockholders.

And if it is true, which is the best debt-to-equity ratio to maximize the company and its

stocks value.

According to Ross (2003) and to Brealey (2003) the capital structure policy which

maximizes the company value also maximizes the return of the stockholders. This

statement is important because through the theories to be studied we are only going

to find methods to show how to maximize the value of the firm, and then we can infer

that it also maximizes the wealth of the stockholders. We are not going to see means

to maximize the wealth of stockholders directly.

3.1 - MODIGLIANI & MILLER

The Modigliani & Miller theories are considered the most important one in the field of

the capital structure of firm. Although their famous Proposition I is considered a non-

realistic approach, it is considered a very good start for the studies later conducted

(ROSS ET AL. 2002) (BREALEY ET AL. 2003).

 14

In their Proposition I, Modigliani & Miller use certain assumptions. First the firms in a

given “class” have equivalent return, i.e. their returns are proportional, so they have a

perfect correlation. The importance of this assumption is to make returns of different

firms, within the same class, homogeneous. The next assumption is that the stocks

of these companies are traded in a perfect market, which means, no taxes, no

trading costs and perfect information (MODIGLIANI & MILLER 1958).

Under these conditions Modigliani & Miller stated their Proposition I, which says “the

market value of any Firm is independent of its capital structure” (MODIGLIANI &

MILLER 1958). This statement may sound unrealistic, given the fact that finance

managers spend a lot of time and money in an effort to choose the best capital

structure of a firm. But it has to be recalled that the Proposition I is for a perfect

market situation.

Following the Proposition I Modigliani & Miller stated a second proposition. From the

fact that the total market value of the firm does not depend on its debt to equity ratio,

and manipulating the equation (1) (ROSS ET AL. 2002) so we can isolate the

variable rs we find equation (2). The equation (2) shows Modigliani & Miller’s

Proposition II, where the cost of equity is proportional to the leverage of the company

because the cost of equity rises with the risk brought to the company by its leverage

(MODIGLIANI & MILLER 1958).

r0= SB+S.rs+BB+S.rb (1)

Where:

r0: return of the firm;

S: value of the firm’s shares;

B: value of the firm’s bonds;

rs: the expected return on shares; and

rb: the interest rate of the firm’s bonds.

 15

rs=r0+BS.(r0-rb) (2)

Where:

r0: return of the firm;

S: value of the firm’s shares;

B: value of the firm’s bonds;

rs: the expected return on shares; and

rb: the interest rate of the firm’s bonds.

According to Brealey (2003) these propositions shows a conservation of value, that

is, the different ways in which the capital of a firm can be divided won’t change its

total value. This means that the only thing at stake when discussing capital structure,

within the assumptions of the propositions, is how the return of the firm is going to be

shared, and not how much of it is going to be created. So, based on Modigliani &

Miller (1958) the capital structure will not affect the firm’s total value, it will only affect

the distribution of its total value.

3.1.1 - CORPORATE TAXES ON MODIGLIANI & MILLER

Following their first paper, Modigliani & Miller (1963) made a correction on their

propositions with the use of tax shields. Tax shields are the benefit the firms can get

on issuing debt because the interest paid for this debt is tax deductible based on the

American tributary legislation.

For their Proposition I, the value of the firm no longer is independent of its capital

structure. Now the firm has an incentive to issue debt, because the interests paid on

them are tax deductible. So with the introduction of taxes the total market value of the

leverage firm can be expressed as the value of an all equity firm plus the tax shield

as in equation (3) (ROSS ET AL. 2002).

Vl= Vu+ B.Tc (3)

Where:
 16

Vl: total value of the leveraged firm;

Vu: total value of the unleveraged firm;

B: value of firm’s bonds; and

Tc: corporate income tax rate.

So with the introduction of taxes the total market value of the firm increases with the

issuing of debt. So the firms should issue as much debt as possible as shown in the

figure (1).

Figure 1 - Value of the leveraged firm as a function of bonds issued

For the Proposition II there is also a change because of the introduction of taxes on

the theory. The tax deductibility of interest rates paid on the debt issued change our

equation (2) on the cost of equity. With the addition of the tax deduction on the

Proposition II we have the equation (4).

rs=r0+BS.1-Tc.(r0-rb) (4)

Where:

rs: the expected return on shares;

rb: the interest rate of the firm’s bonds;

r0: return of the firm;

S: value of the firm’s shares;

B: value of firm’s bonds; and

Tc: corporate income tax rate.

So with the new equation we have the figure (2) below on how the cost of equity rises

with the issue of debt.

 17

Figure 2 - Cost of equity as a function of bonds issued

The model with taxes let us see the increase in value when the company issues

bonds. When not considering taxes, the model does not show any change in the

value of the firm with the issue of bonds by the firm, the model is then corrected

showing the increase in value of the firm because of the tax deductibility of the

interest paid on the bonds.

3.1.2 - MILLER’S MODEL ON PERSONAL TAXES

On the previous papers, Modigliani & Miller already stated that the gains from debt

financing for the corporations may be reduced by personal income taxes on interest

(MODIGLIANI & MILLER 1963). But they never mention exactly how it is done, and

how much it can reduce the gains on leverage for the firms.

On a later paper, Miller (1976) introduces the actual impact of personal taxes on the

capital structure of a firm. In this paper he shows how the total market value of a

leveraged firm can be expressed as a function of the value of the unleveraged firm,

and the tax rates for corporations and for stock and bond holders.
 18

In this new model the total market value of the leveraged firm is shown as the value

of the unleveraged firm plus an expression (the tax benefits in function of the tax

rates for corporation and for personal income on stocks and bonds) multiplied by the

amount of debt issued by the firm, as seen in equation (5) (MILLER 1976).

Vl=Vu+1-1-Tc.1-Ts1-Tb.Bl (5)

Where:

Vl: total value of the leveraged firm;

Vu: total value of the unleveraged firm;

Tc: corporate income tax rate;

Ts: personal income tax rate on shares;

Tb: personal income tax rate on bonds; and

Bl: value of the leveraged firm’s bonds.

From equation (5) we can see that when all tax rates are equal zero then the value of

the leveraged firm is equal the unleveraged firm, just as the original Proposition I.

And also when the tax rates for personal income from stocks and from bonds are

equal, the value of the leveraged firm becomes the value of the unleveraged firm plus

the tax shield Tc.Bl, exactly like the equation (3) (MILLER 1976).

Also, in special cases where (1-Tc).(1-Ts)=(1-Tb) – like the case stated above in which

all the taxes are equal to zero – there is no advantage in acquiring debt, i.e. the value

of the leveraged firm is equal to the unleveraged. That happens because the tax

benefit from interest on corporate taxes will be exactly offset by the higher taxes on

personal income from bonds and stocks (ROSS 2003).

On the graphs below we can see how the tax rates influence on the gain from

leverage for the firms, keeping everything else constant. On figures (3) and (4) we

can see how the increase on corporate income taxes and on personal income taxes
 19

from stocks increases the gains from leverage. It happens because with the high

taxes on income from stocks the cost of bonds becomes smaller.

Figure 3 - Value of the leveraged firm as a function of the Corporate Income Tax Rate

Figure 4 - Value of the leveraged firm as a function of the Personal Income Tax on Stocks

On the figure (5) we can see how the gains from leverage decrease exponentially

with the increase on the tax rate from personal income from bonds. We can also see

that for certain high rates, the taxes on bonds eat up all the tax benefits from

leverage, to a point that the gains from leverage actually become a lost.

Figure 5 - Value of the leveraged firm as a function of the Personal Income Tax on Bonds
 20

4 - BRAZILIAN TRIBUTES

As we could see before the Modigliani & Miller theories on capital structure are

fundamentally based on the tributary legislation of their context. The problem to be

here attacked is the fact that the U.S. tributary system of the 50’s and 60’s is very

different from the tributary system we have in Brazil nowadays.

To try to solve this question we are going to see the Brazilian tributes that may affect

Miller’s theory on the capital structure subject to the Brazilian Tributary Code.

To analyze Miller’s model on personal taxes we have to discuss the three kind of

taxes used in the model, the corporate income tax, the personal income tax on

bonds, and the personal income tax on stocks. In Brazil, the taxes on corporate

income are the income tax (Imposto de Renda) on corporations, and the social

contribution over net profit (Contribuição Social Sobre Lucro Líquido), and there are

some differences to the American law on the deductibility.

On the personal taxes, we can divide in the same way as Miller (1976) in income tax

from bonds and from stocks, but there is also some differences on the personal taxes

when compared to the American law (Lei 7.689/88) (Lei nº 11.033, de 2004)

(RIR/1999).

4.1 – CORPORATE INCOME TAX

On the corporate income tax, in the Brazilian regulation there are two brackets to

define the tax rate to be charged by the state in the form of income tax. The

companies are subject to a tax rate of 15%, on income lower than R$20,000.00 per

month. And are subject to a tax rate of 25% on income over the limit of R$20,000.00

per month (Lei 9.249/95).

 21

There is also another tribute to be paid by the corporations over income, which is the

social contribution over net profit. This contribution is charged on a certain rate over

the net income before the income tax provision, so the income tax paid is not

deductible from the contribution. The rate of this contribution is 9% over the net profit

before the income tax (Lei nº 11.727, de 2008).

The total corporate income tax rate can be defined then as the sum of these two tax

rates. Considering the reality that listed companies all have an income higher than

R$20,000.00 the income tax rate of the companies can be considered as 25%. And

as the social contribution over net profit is 9%, the total corporate income tax rate in

Brazil is 34%.

It is also important to note that the dividends paid by the companies to its

shareholders cannot be deducted from these corporate taxes. On the other hand,

there is an instrument on the Brazilian legislation that allows the payment of profit to

the shareholders to be deducted from those taxes mentioned above.

This instrument is the interest paid on equity, which is the amount paid to the

shareholders as an interest rate over the capital invested on stocks of the company.

It is limited to the long term interest rate (TJLP1) which is the interest rate used by the

government to concede long term loans. Also, the interest rate paid on debt issued

by the company is deductible on the income tax and the social contribution over net

profit (Lei 9.249/95).

The firm has then, the option to pay its dividends all in the form of dividends itself, or

partly as interest on equity to the limit of the long term interest rate in accordance to

the Brazilian legislation (Lei 9.249/95). The choice for the firm is then between paying

all the dividend as dividend itself with a 34% tax rate (the corporate income tax rate),

1 The TJLP is the long term interest rate instituted by MP 684/94 to regulate the tax rate used by the
BNDES (National Bank for Economic and Social Development) for its activities in the economic and
social development of the country, mainly directed for credit issued for entrepreneurs and for the
custody of a variety of worker funds.
 22

or pay it partially as the interest on equity with a 15% tax rate (the personal tax on

equity, as seen in the next section). The optimum choice for the firm is then to pay its

profits to the shareholders as interest on equity to the limits established by the law,

before paying dividends.

In the table 1 below we see the benefits for the use of interest on equity. It shows

how the net profit can increase by 34% (the corporate income tax rate) of the interest

on equity paid to the shareholders when compared to a company that does not use

interest on equity, and use only dividends.

Table 1 - Benefits for the use of Interest on Equity

Without
With Interest on Equity Interest on
Equity

(+)Income (P) P P P
(-)Interest on EquityTJLP x Equity TJLP.S
Income - Interest on
(=)Income Before Tax P-(TJLP.S) P
Equity
(-)Income Tax (Tc) Income Before Tax x Tc [P-(TJLP.S)].34% P.34%
Dividends (or Dividends-
(-)Dividends D- (TJLP.S) D
Interest on Equity)
Income - Interest on P-(TJLP.S)-{[P-(TJLP.S)].34%}-[D-(TJLP.S)]
P-P.34%-D
(=)Net Profit Equity - Income Tax - P-D-34%.(P-TJLP.S)
P-D-34%.P
Dividends P-D-34%.P + (34%.TJLP.S)

4.2 - PERSONAL INCOME TAX ON EQUITY

On the personal income tax on equity, the Brazilian legislation establishes a tax rate

of 15% on the net profit from stocks, to be paid on the sale of the stock.

Another point to be considered when analyzing the personal income tax on equity is

the fact that dividends paid by the corporations are free of taxes for the stockholders,

as corporations cannot deduct it from their income taxes. On the other hand,

shareholders have to pay the 15% income tax on the interest over invested capital

when it is paid by the firms. So, when the companies can deduct a payment to

stockholders from their income taxes, the stockholders themselves have to pay
 23

income tax on it, and when the companies cannot deduct it, the stockholders are tax

free on this payment (Lei nº 11.033, de 2004).

4.3 - PERSONAL INCOME TAX ON DEBT

The personal income on bonds is taxed in a different way. It has tax brackets

depending on the duration of the bond, or the duration holding the bond (Lei nº

11.033, de 2004).

The tax bracket is higher for bond hold for less than six months, which are taxed at a

rate of 22.5%. For bonds between six and twelve months the tax rate is 20%. A tax

rate of 17.5% is charged over bonds lasting from twelve to twenty four months. And

for bonds of over twenty four months the tax rate is only 15% as in the table 2 bellow

(Lei nº 11.033, de 2004).

Table 2 - Personal Income Tax Rate on Bonds

Duration of the bond Personal Income Tax Rate on

Bonds
b < 6 months 22.5%
6 months < b < 12 months 20%
12 months < b < 24 months 17.5%
b > 24 months 15%

It is also important to remember that the firms can deduct the interest rates paid to

bondholders from their corporate income taxes.

 24

5 - MILLER'S MODEL AND BRAZILIAN TAX STRUCTURE

In the previous sections it was seen how the capital structure theories, mainly Miller’s

Model, work on the United States tax environment, helping to increase the value of a

firm. There was also seen how the Brazilian legislation works on income taxes, both

corporate and personal, either for equity or for debt. Now it will be shown how these

theories may work in the Brazilian Taxes environment.

First, the Modigliani & Miller Proposition II depends on the corporate income tax as

seen in equation (4). In the Brazilian legislation the rates for corporate income tax is

34%

Exchanging the value of the tax rate mentioned above in the equation (4) will give us

equation (6), where we can see the effects of the Brazilian tax rates on the equation,

to show how the value of the company is affected by the issue of bonds in Brazil.

rs=r0+BS.66%.(r0-rb) (6)

As seen previously, the personal income tax on bonds will depend on the duration of

the bond, but this will make a small difference in the capital structure of the firm, as

will be shown here. Using equation (5) and exchanging Tc and Ts for its rates in

Brazil, we will get equation (7).

Vl=Vu+1-0.5611-Tb.Bl (7)

Where

Vl: total value of the leveraged firm;

Vu: total value of the unleveraged firm;

Tb: personal income tax rate on bonds; and

Bl: value of the leveraged firm’s bonds.

From equation (7) we may have four different rates for Tb depending on the duration

of the bonds, and from those four different rates we get equation (8) for 22.5%. From
 25

equation (8) we can see that if the firm decides to finance itself with bonds that have

durations of less than six months it will increase the value of the leveraged firm on

0.276 dollars per dollar issued in bonds when compared to the unleveraged firm.

Vl=Vu+0.276Bl (8)

Where

Vl: total value of the leveraged firm;

Vu: total value of the unleveraged firm; and

Bl: value of the leveraged firm’s bonds.

In equation (9) we see how the Miller’s Model works for the 20% personal income tax

on bonds rate, that is when the bonds duration is between six and twelve months.

From equation (9) we can demonstrate how the firm will increase its leveraged value

in 0.299 dollars per dollar of bonds issued when compared to the unleveraged firm, if

it decides to issue bonds with duration between six and twelve months.

Vl=Vu+0.299Bl (9)

Where

Vl: total value of the leveraged firm;

Vu: total value of the unleveraged firm; and

Bl: value of the leveraged firm’s bonds.

Equation (10) shows the Miller’s Model on Brazilian taxes with debt issued with

durations between twelve and twenty four months, with the 17.5% tax rate. The

equation (10) shows how the firm can increase its leveraged value by 0.32 dollars

per dollar issued in bonds with durations between twelve and twenty four months

when compared to the value of the unleveraged firm.

Vl=Vu+0.320Bl (10)

Where

Vl: total value of the leveraged firm;

 26

Vu: total value of the unleveraged firm; and

Bl: value of the leveraged firm’s bonds.

When adapting Miller’s Model to the 15% tax rate of personal income tax on bonds

with duration of over twenty four months we get equation (11). It shows how the

value of the leveraged firm can be increased by 0.34 dollars per dollar issued on

bonds with durations of over twenty four months, when compared to the value of the

unleveraged firm.

Vl=Vu+0.340Bl (11)

Where

Vl: total value of the leveraged firm;

Vu: total value of the unleveraged firm; and

Bl: value of the leveraged firm’s bonds.

From the results above we can see how the value of the leveraged firm is always

increased by the issuing of debt. Also the issue of debt increases the value of the

firm indefinitely. There is only a difference in the amount of value added by the firm

with the issue of debt depending on its duration, where the shorter the duration of the

bond, the slower the value of the firm will be increased by the issue of debt. Figure

(6) shows how the different gains of leverage apply depending on the duration of the

bonds, and so the tax bracket in which the personal income tax rate on bonds the

bondholders will be included.

Figure 6 - Gain of leverage as a function of the amount of Bonds issued (each line represents a

different tax bracket on the Personal Income Tax on Bonds)

 27

6 - FINAL CONCLUSIONS

This study started from the question of how the Miller’s Model on Personal Taxes

would apply to Brazilian tributes. To solve the question there was made a

bibliographic review of the papers leading to the final Miller paper defining the model.

There was also made a bibliographic review on the Brazilian legislation, regarding

the laws that could interfere in the adaptation of the model to Brazilian companies.

These laws were referring to income taxes, either corporate or personal, either on

bonds or stocks.

Analyzing the Brazilian law we found that the corporate taxes were divided in two

tributes, the corporate income tax, and the social contribution on net profit that

combined become what here was called as corporate income tax. The total corporate

income tax in Brazil is then 34%. 25% of corporate income tax plus 9% on the social

contribution on net profit (Lei 9.249/95) (Lei nº 11.727, de 2008).

Also it is worth noting the existence of the interest on equity which may be used by

corporations to pay dividends, up to a limit established by law (TJLP), that can be

deducted from the corporate income tax. This is important, because the firms should

then, when willing to pay dividends, pay as much of it as possible as interest on

equity, which will suffer a 15% tax rate, and only then pay dividends at a tax rate of

34%. There was also showed how it interferes in the value of the firm when opting to

use the maximum interest on equity as possible in conformation with the advised (Lei

9.249/95).

On the matter of the personal income taxes, the personal income tax rate on shares

in Brazil is 15%.

The personal income tax rate on bonds on the other hand, depends on the duration

of the bond, and may vary from 15% on the longer bonds to 22.5% on the shorter
 28

bonds (Lei nº 11.033, de 2004). This different tax brackets depending on the duration

of the bond makes it preferable for the firm to issues long term bonds, because of the

lower taxes for longer bonds.

With these rates we may see that with Brazilian taxes, the firms have an increase in

value by the issuing of debt. The durations of the bonds will change the pace in

which the value of the firms will be increased, but despite it, we saw that at any

duration of bonds, the firms will increase its value indefinitely when issuing bonds. By

this model then, the firm should indefinitely issue debt to increase its value as much

as possible.

Besides that, it is widely known that there are some limits to the use of debt by the

companies that are not accounted for in Miller’s Model on Personal Taxes. The limits

to the use of debt are bankruptcy costs and agency costs.

The bankruptcy costs can be divided in direct and indirect costs, basically the direct

costs are the legal and administrative costs of liquidation or reorganization of the

company, usually in these situations lawyers, administrators and accountants may

charge big fees, which make these costs very high. The indirect costs are the

difficults that arise to conduct the business during finance distress situations. It

becomes harder to negotiate with customers and suppliers, making supplier’s prices

higher and sale prices lower (ROSS ET AL. 2002).

Agency costs occur when there is a conflict of interest, in this case between

bondholders and stockholders. These agency costs arise in moments of financial

distress, when there are incentives to stockholders to take more chances, to

underinvest and to take extra dividends from the company. It may happen because

the stockholders do not have the majority of the money invested, but have the control

of the company, creating then a conflict of interest (ROSS ET AL. 2002).

 29

The next step on this work should now to make a field research to analyze how

Brazilian companies choose their capital structure in the market. Searching for listed

companies and their debt to equity ratio to define if they are in accordance or not to

the results found on this study, and how much the limits on the use of debt applies to

these companies.
 30

REFERENCES

Modigliani, F.; Miller, M. H. The Cost of Capital, Corporation Finance and the

Theory of Investment. The American Economic Review, v. 48, n. 3, p. 261-297,

Jun,1958.

Modigliani, F.; Miller, M. H. Corporate Income Taxes and the Cost of Capital: A

Correction. The American Economic Review, v. 53, n. 3, p. 433-443, Jun, 1963.

Miller, M. H. Debt and Taxes. The Journal of Finance, v. 32, n. 2, p. 261-275, mai,

1977.

Ross, S. A.; Jaffe, J. F.; Westerfield, R. W. Corporate Finance. 6ª Edição. São

Paulo: McGraw-Hill, 2002.

Brealey, R.A.; Myers, S. C. Principles of Corporate Finance. 7ª Edição. São Paulo:

McGraw-Hill, 2003.

BRAZIL. Lei nº 11.033, de 19 de janeiro de 2004

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Renda - RIR/99)

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