CAPITAL STRUCTURE AND TAX CONVEXITY WHEN THE MATURITY OF DEBT IS FINITE

Abstract

We examine the impact of tax convexity on the optimal leverage, the optimal default barrier, and the credit spread. Contrary to previous papers, debt maturity in our setting is finite. We find that maturity plays a crucial role to fully capture the effect of tax convexity. Our results show that tax convexity has a substantial impact on the optimal default boundary when the maturity is intermediate. We argue that, in the presence of tax convexity, equityholders inject cash into the firm because they weigh the value surplus they achieve from delaying default against the loss they incur, given the absolute priority rule, when the firm fails to fully redeem the debt’s principal at maturity. We also find that the longer is the maturity, the stronger is the negative impact of tax convexity on the optimal leverage.