On miller's equilibrium and the stock versus bond puzzle

Abstract

We re-examine the Miller's (1977) equilibrium to explain the stock versus bond puzzle. We model the conflict between taxable and non-taxable entities, under both risk neutrality and risk aversion, incorporating the effects of differential individual taxation of capital gains versus dividends. and all relevant bankruptcy costs. Our analysis shows that there exists: (i) a unique optimal debt ratio for an individual firm owned by both risk-neutral as well as risk-averse agents, (ii) an equilibrium interest rate different from that postulated by Miller (1977), and (iii) a clientele effect for stocks and bonds, also known as the stock versus bond puzzle, only under the risk-neutral behavior of agents. We show that risk averse behavior of agents under pareto-optimal risk-free debt financing resolves this puzzle Finally, the empirical investigation of aggregate data lends support to the theoretical findings and to practitioner assertions.