Tax Options, Capital Structure, and Miller Equilibrium: A Numerical Illustration

Using both debt and equity increases the aggregate value of tax options on the firm. Therefore, firm value may depend on capital structure, even in a Miller equilibrium. A simple two-state pricing model is used to create a numerical example of a levered firm. The example demonstrates the existence of an optimum that involves a mixed capital structure, even when bankruptcy is costless. Whether firms or individuals capture the additional tax option value, leverage--either firm issued or homemade"--affects firm value in a world with tax options.