Government as the Firm's Third Financial Stakeholder: Impact on Capital Investment Decisions, Capital Structure, Discount Rates, and Valuation

We extend Myers' (1974) adjusted present value method and modify Modigliani and Miller's (1958, 1963) capital structure propositions by adding government as the firms' third major financial stakeholder. Government is a major stakeholder because it collects income taxes, is instrumental in establishing the business environment, and provides business infrastructure to corporations. We assume that government's stake is an implicit form of capital and, consequently, any return or benefit derived by the firm from this implicit capital will affect firm value. As a result, tax structure significantly impacts relative stakeholder values, capital investment decisions, and capital formation. Only in the special case when the firm receives explicit benefits and when the return on government's implicit capital is equal to the firm's cost of equity capital will corporate taxes not impact firm value and capital investment decisions. Although tax irrelevance and the conservation of value principle may hold true within a domestic economy with a homogenous tax structure, our three-stakeholder model demonstrates that corporate income taxes become relevant for investment decisions in a globally competitive economy with heterogeneous tax structures. Thus, our model addresses the apparent inconsistencies between existing theory, which characterizes corporate taxes as nondistortionary, and empirical findings, which demonstrate that taxes reduce investments, growth, and valuation ratios.