Interest Rates, Taxes, Bankruptcy and Financing Decisions

Abstract

While most efforts in corporate finance focus on how firm characteristics influence financing decisions, recent studies indicate that interest rates can influence tax shields and bankruptcy costs, affecting the optimal capital structure. Using a yield curve factor model, I examine how interest rates affect the debt-equity choice. While the T-bill yield affects the likelihood of debt financing positively, the T-bond yield and the yield curve volatility affect the likelihood of debt financing negatively. These effects are partially due to the changes of tax shields and bankruptcy costs caused by the interest rate movements.