Miller’s Equilibrium and Uncertainty

Abstract

This paper highlights the arbitrage activity by firms in Miller’s (1977) equilibrium when consumers face (short) selling constraints to restrict tax arbitrage. In this competitive equilibrium firms create risky taxpreferred securities that divide investors into strict tax clienteles; any changes in debt-equity ratios by individual firms have no real effects on consumers because other firms undo them. While DeAngelo and Masulis obtain this equilibrium with a full set of primitive bonds and a full set of primitive shares, the formalisation here relies only on a full set of conventional securities for firms to buy and sell. Once firms are constrained (for example, when the capital market is incomplete), Kim et al. (1979), Taggart (1980), Kim (1982) and Auerbach and King (1983) identify investor leverage clienteles. This paper demonstrates the arbitrage activity by firms that is implicit in Sarig and Scott (1982) who argue these clienteles are eliminated by standard portfolio theory. Show more