Tax Benefits Of Debt Research Articles

Dynamic Models of Investment Distortions

This paper studies the interaction between corporate financing decisions and investment decisions in a dynamic framework. When the production decision involves an expansion option, the firm trades off tax benefits of debt against two costs of debt financing, namely the investment distortion related to exercise of the expansion option and the loss of a valuable expansion opportunity if the firm defaults. The optimal capital structure is all equity for firms with more value in growth options (or intangible assets) and tends to involve debt financing for firms with more value in tangible assets.

Optimal Capital Structure and Industry Dynamics

ABSTRACTThis paper provides a competitive equilibrium model of capital structure and industry dynamics. In the model, firms make financing, investment, entry, and exit decisions subject to idiosyncratic technology shocks. The capital structure choice reflects the tradeoff between the tax benefits of debt and the associated bankruptcy and agency costs. The interaction between financing and production decisions influences the stationary distribution of firms and their survival probabilities. The analysis demonstrates that the equilibrium output price has an important feedback effect. This effect has a number of testable implications. For example, high growth industries have relatively lower leverage and turnover rates.

Are Firms Underleveraged? An Examination of the Effect of Leverage on Default Probabilities

ABSTRACTA commonly held view in corporate finance is that firms are less leveraged than they should be, given the potentially large tax benefits of debt. In this paper, I study the effect of firms' leverage on default probabilities as represented by the firms' ratings. Using an instrumental variable approach, I find that the leverage's effect on ratings is three times stronger than it is if the endogeneity of leverage is ignored. This stronger effect results in a higher impact of leverage on the ex ante costs of financial distress, which can offset the current estimates of the tax benefits of debt.

Joint Production and Financing Decisions: Modeling and Analysis

This paper develops models to make production and financing decisions simultaneously in the presence of demand uncertainty and market imperfections. While the Modigliani and Miller propositions demonstrate that a firm's investment and financing decisions can be made independently in a perfect capital market, our models illustrate how a firm's production decisions are affected by the existence of financial constraints. We analyze the interactions between a firm's production and financing decisions as a tradeoff between the tax benefits of debt and financial distress costs. Our numerical examples illustrate that a traditional all-equity manufacturing company can improve its performance significantly by making real and financial decisions together. The results illustrate greater firm value sensitivity to production decisions than to financing decisions and that low-margin producers face significant risk in not coordinating production and financing decisions.

Corporate Capital Structure in the United Kingdom: Determinants and Adjustment

In this paper three contributions are made. First, empirical support is provided for the 'trade-off' model of corporate capital structure where companies borrow to take advantage of the tax benefits of debt, which they set against possible costs of overindebtedness. Second, it is shown empirically how companies adjust their balance sheets when borrowing is out of equilibrium, through adjustments to dividend payments, new equity issues and to a lesser extent capital investment. Third, these factors are incorporated within an aggregate model that quantifies the process and speed of balance sheet adjustment in the economy as a whole.

Optimal Capital Structure and Industry Dynamics

This paper provides a competitive equilibrium model of capital structure and industry dynamics. In the model, firms make financing, investment, entry, and exit decisions subject to idiosyncratic technology shocks. The capital structure choice reflects the tradeoff between the tax benefits of debt and the associated bankruptcy and agency costs. The interaction between financing and production decisions influences the stationary distribution of firms and their survival probabilities. The analysis demonstrates that the equilibrium output price has an important feedback effect. Due to this effect, the model generates a number of new testable predictions. In particular, it is shown that high-growth industries have relatively lower leverage and lower turnover rates.

Estimating the Tax Benefits of Debt

Estimating the Tax Benefits of Debt

ESTIMATING THE TAX BENEFITS OF DEBT

The standard approach to valuing interest tax shields assumes that full tax benefits are realized on every dollar of interest deduction in every scenario. The approach presented in this paper takes account of the possibility that interest tax shields cannot be used in some scenarios, in part because of variations in the firm's profitability. Because of the dynamic nature of the tax code (e.g., tax‐loss carrybacks and carryforwards), it is necessary to consider past and future taxable income when estimating today's effective marginal tax rate. The paper uses a series of numerical examples to show that (1) the incremental value of an extra dollar of interest deduction is equal to the marginal tax rate appropriate for that dollar; and (2) a firm's effective marginal tax rate (and therefore the marginal benefit of incremental interest deductions) can actually decline as the firm takes on additional debt.Based on marginal benefit functions for thousands of firms from 1980–1999, the author concludes that the tax benefits of debt averaged approximately 10% of firm value during the 1980s, while declining to around 8% in the 1990s. By taking maximum advantage of the interest tax shield, the average firm could have increased its value by approximately 15% over the 1980s and 1990s, suggesting that the consequences of being underlevered are significant. Surprisingly, many of the companies that appear best able to service debt (i.e., those with the lowest apparent costs of debt) use the least amount of debt, on average. Treasurers and CFOs should critically reevaluate their companies' debt policies and consider the benefits of additional leverage, even if taking on more debt causes their credit ratings to slip a notch.

How Big Are the Tax Benefits of Debt?

I integrate under firm‐specific benefit functions to estimate that the capitalized tax benefit of debt equals 9.7 percent of firm value (or as low as 4.3 percent, net of personal taxes). The typical firm could double tax benefits by issuing debt until the marginal tax benefit begins to decline. I infer how aggressively a firm uses debt by observing the shape of its tax benefit function. Paradoxically, large, liquid, profitable firms with low expected distress costs use debt conservatively. Product market factors, growth options, low asset collateral, and planning for future expenditures lead to conservative debt usage. Conservative debt policy is persistent.

The Trade-off Model with Mean Reverting Earnings: Theory and Empirical Tests

The biggest criticism of the traditional trade-off theory of capital structure is that it predicts a positive relationship between earnings and leverage, contradictory to well-established empirical evidence. One possible explanation for this discrepancy might lie in the mean reverting nature of corporate earnings. We therefore re-formulate the trade-off model, with mean reverting earnings. The optimal leverage ratio is computed in the usual manner, by trading off the tax benefits of debt with its associated financial distress costs. Our main result is a negative relationship between optimal leverage and earnings. The model also highlights the importance of the earnings reversion parameter in determining the optimal capital structure. The major implications of the model are supported by empirical tests carried out with Compustat data for firms in the S&P 500 Index.

How Big are the Tax Benefits of Debt?

This paper estimates how much deductibility contributes to firm value. By integrating under firm-specific benefit functions, the present value tax benefit of interest deductions is estimated to equal approximately 10% of firm value. The economy-wide benefit peaked at about $118 billion in 1990 (or about $60 billion, net of the personal tax penalty). The implicit cost of debt is inferred by observing where firms locate on their interest-deduction benefit curves. Paradoxically, profitable firms with low apparent costs are very conservative in their pursuit of interest deductions. Conservative debt policy is persistent and firms do not use their financial slack to fund future capital expenditures or acquisitions.

Calculating The Cost of Capital of an Unlevered Firm For Use in Project Evaluation

The adjusted present value requires an estimate of the cost of equity of an unlevered firm. Traditional approaches for calculating this cost assume that firms maintain a constant market-value percentage of debt when in fact firms typically use a book-value percentage of debt. In this paper, we present an approach to correctly estimate the cost of equity of an unlevered firm whenever the firm fails to maintain a constant market-value-based leverage ratio. We also demonstrate that both the Modigliani and Miller (1963) and Miles and Ezzell (1980) approaches may yield substantial valuation errors when firms determine debt levels based on book-value percentages. In contrast our method makes no errors as long as managers know the marginal tax benefit of debt.

Interest Rate Uncertainty and the Optimal Debt Maturity Structure

As demonstrated by Boyce and Kalotay (1979) and Brick and Ravid (1985), the use of long-term debt may be preferred because of tax-related advantages. Brick and Ravid show that if there exists a tax advantage to debt and nonstochastic interest rates, long-term debt will increase the present value of the tax benefits of debt if the term structure of interest rates, adjusted for risk of default, is increasing. A decreasing term structure, on the other hand, calls for short-term debt. The present paper extends the tax-induced argument of Brick and Ravid to allow for the presence of stochastic interest rates. Once interest rates are uncertain, pricing even under risk neutrality becomes a complex issue. We analyze the debt maturity decision under two competing pricing equations: the return to maturity expectations hypothesis and the local expectations hypothesis. (This terminology is used in Cox, Ingersoll, and Ross (1981) and Campbell (1986).) Under uncertainty, a debt capacity factor will create an additional incentive to issue long-term debt. Our other results may be interpreted to indicate that if the term premium, the difference between the implied forward interest rate and the future expected spot rate, is positive (sufficiently negative) then long-term (short-term) debt maturity strategy is optimal.

INTEREST RATE UNCERTAINTY AND THE OPTIMAL DEBT MATURITY STRUCTURE

As demonstrated by Boyce and Kalotay (1979) and Brick and Ravid (1985), the use of long-term debt may be preferred because of tax-related advantages. Brick and Ravid show that if there exists a tax advantage to debt and nonstochastic interest rates, long-term debt will increase the present value of the tax benefits of debt if the term structure of interest rates, adjusted for risk of default, is increasing. A decreasing term structure, on the other hand, calls for short-term debt. The present paper extends the tax-induced argument of Brick and Ravid to allow for the presence of stochastic interest rates. Once interest rates are uncertain, pricing even under risk neutrality becomes a complex issue. We analyze the debt maturity decision under two competing pricing equations: the return to maturity ex? pectations hypothesis and the local expectations hypothesis. (This terminology is used in Cox, Ingersoll, and Ross (1981) and Campbell (1986).) Under uncertainty, a debt capacity factor will create an additional incentive to issue long-term debt. Our other results may be interpreted to indicate that if the term premium, the difference between the implied forward interest rate and the future expected spot rate, is positive (sufficiently negative) then long-term (short-term) debt maturity strategy is optimal.