Capital structure decision in the presence of tax treatment uncertainty

The capital structure decision is examined in the presence of uncertainty regarding the treatment of the firm's debt by the tax authorities. Aggressive use of debt financing as a tax minimization device, a policy prescription of the Modigliani–Miller tax-corrected model, would invite action on the part of the tax authorities, namely classification of the firm's debt as equity for tax purposes. An optimization model which takes this phenomenon into account is developed. An important implication of the model is that an optimal capital structure involves a judicious combination of both debt and equity.