UNANTICIPATED INFLATION, TAXATION, AND COMMON STOCKS

This paper focuses on the effects of unanticipated inflation on the market value of equity in a system with corporation tax and historic cost depreciation. It is shown that there exists a unique combination of debt and equity under which inflation neutrality is obtained, Whether or not unanticipated inflation hurts or benefits the stockholders in a particular firm depends upon a number of conditions. These include the depreciation rate of its assets relative to the amortization rate of its debt. Finally, the present tax system is contrasted with a fully indexed system involving replacement cost depreciation and indexation     

INFLATION,INVESTMENT, AND DEBT

In this paper the effect of inflation on firms' investment and debt-financing decisions is examined. Inflation affects optimal investment and financing directly through the probability of accounting loss and the real value of depreciation and interest tax shields. In addition, when corporate and differential personal taxes cause investment and financing decisions to interact, inflation has indirect effects on these decisions through their interactions. In general, the overall effects of inflation on optimal investment and debt are ambiguous in sign. For tax-exempt firms, however, optimal investment and debt are independent of inflation. For firms that are always in a tax-paying position, higher inflation reduces optimal investment without affecting optimal debt. Furthermore, inflation causes total firm value to decrease if the depreciation rate exceeds the firm's debt/asset ratio.     

Valuation of the Debt Tax Shield

In this study, we use cross–sectional regressions to estimate the value of the debt tax shield. Recognizing that debt is correlated with the value of operations along nontax dimensions, we estimate reverse regressions in which we regress future profitability on firm value and debt rather than regressing firm value on debt and profitability. Reversing the regressions mitigates bias and facilitates the use of market information to control for differences in risk and expected growth. Our estimated value for the debt tax shield is approximately 40 percent (10 percent) of debt balances (firm value), net of the personal tax disadvantage of debt.     

Debt Management under Corporate and Personal Taxation

The presence of long-term debt in a corporation's capital structure is shown to give rise to a valuable tax-timing option that can be exercised by the firm on behalf of its shareholders. This option, which is not available if the firm is fully equity financed, implies that leverage will have a positive tax effect on total firm value even if there is no such effect associated with the tax deductibility of the coupon interest payments on debt. The more volatile interest rates and bond prices are, the more valuable the tax-timing option and the larger the favorable impact of debt on shareholder wealth.     

On the value and determinants of the interest tax shields

We use a dynamic model of the firm to ascertain both the value and the determinants of the debt tax shields. For a representative U.S. firm, we find that the value of the interest tax shields represents less than 5 % of firm value, and it varies considerably across U.S. industries. Our results also show that this component of firm value behaves counter-cyclically over the business cycle. Finally, besides the interest rate on debt and the corporate income tax rate, we find that the curvature of the production function is one of the main determinants of the tax advantage of debt.     

Share values, inflation, and escalating tax rates

The interaction of inflation with a progressive tax system has been known to cause tax rates, and thus tax liabilities, to escalate with nominal income. Often blamed for having undesirable effects on investment and wealth, this feature of modern tax systems has not received formal treatment in the literature. The present study examines the impact of this inflation-related phenomenon upon the value of corporate equity within the framework of partial equilibrium. It is shown that the combination of moderate inflation and a mildly progressive rate structure may have a substantial adverse effect on share values, an effect sharply increasing with the firm's real growth rate. These results provide a partial explanation for the apparent conflict between the Fisherian hypothesis and the commonly observed inverse relationship between the rate of inflation and the deflated value of stock price indices. To the extent that occasional adjustment of tax schedules does not prevent taxpayers from being pushed toward higher tax brackets, these results suggest a sizable potential benefit from full indexation of tax rates in an economy suffering from chronic inflation. They also confirm the belief that failure to do so is expecially harmful to economic growth.     

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.     

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.     

BETAS AND DEBT MANAGEMENT WITHIN THE UK TAX ENVIRONMENT

Tax complexities relating to corporate tax losses, induced by debt finance, and to the differential tax treatment of equity and sterling debt, are introduced into corporate valuation. The after personal tax value of the geared firm can be less than that of the equivalent ungeared firm. Also, debt-induced tax losses can create negative betas. These fiscal effects are incorporated into degearing formulae under active and passive debt management policies.     

Reformulating Tax Shield Valuation: A Note

Standard financial theory (in the absence of agency costs and personal taxes) implies that each dollar of debt contributes to the value of the firm in proportion to the firm's tax rate. To derive this result, incremental debt is assumed permanent. This paper shows that when the firm acts to maintain a constant market value leverage ratio, the marginal value of debt financing is much lower than the corporate tax rate. Since Hamada's 2 unlevering procedure for observed equity betas was derived under the assumption of permanent debt, we derive an unlevering procedure consistent with the assumption of a constant leverage ratio.     

Determinants of corporate borrowing: A note

In his article Determinants of Corporate Borrowing, Myers (1977) says that it is not guaranteed that the maximum value of the firm is reached before the maximum value of the debt is utilized in the case in which the interest payment is fully tax deductible, but the tax shield is lost if the firm goes bankrupt. I have shown here that even in such a case the maximum value of the firm will always be achieved before the maximum available debt is utilized.     

Interest Tax Shields: A Barrier Options Approach

There is a link between barrier options and tax shields of interest expense. We combine this link with a traditional valuation approach, to present practical valuation formulas for interest tax shields in three debt scenarios with risk of default: (1) constant debt, (2) delayed debt, and (3) debt refinancing. In all cases, default and refinancing are contingent on the random evolution of the income of the firm. For each scenario, we work out sensitivity analysis of the value of tax shields with respect to income, growth, systematic and business risk, risk-free interest rate, interest coverage ratio covenant, and the firm??s refinancing strategy.     

Convertible calls and security returns

The study examines the impact of convertible security calls on securityholder's wealth. On average common stock values fall by approximately two percent at the announcements of convertible debt calls, but common stockholder's wealth is unaffected by convertible preferred stock calls. These findings are consistent with a corporate tax effect. A small average decrease in firm value is also found at the announcements of convertible debt calls. The study raises, but leaves unanswered, the interesting question of what motivates managers to make capital structure decisions that reduce stockholder wealth and firm value.     

How Big is the Tax Advantage to Debt?

This paper uses an option valuation model of the firm to answer the question, “What magnitude tax advantage to debt is consistent with the range of observed corporate debt ratios?” We incorporate into the model differential personal tax rates on capital gains and ordinary income. We conclude that variations in the magnitude of bankruptcy costs across firms can not by itself account for the simultaneous existence of levered and unlevered firms. When it is possible for the value of the underlying assets to jump discretely to zero, differences across firms in the probability of this jump can account for the simultaneous existence of levered and unlevered firms. Moreover, if the tax advantage to debt is small, the annual rate of return advantage offered by optimal leverage may be so small as to make the firm indifferent about debt policy over a wide range of debt-to-firm value ratios.     

The capital structure puzzle revisited

Corporate finance researchers have long been puzzled by lowcorporate debt ratios given debt's corporate tax advantage.This article recognizes that firm value typically reflects agrowing stream of earnings, while current debt reflects a nongrowingstream of interest payments. Debt to value is therefore a distortedmeasure of corporate tax shielding. Even with very small debt-relatedcosts, this may explain the observed magnitude and cross-sectionalvariation of debt ratios. Since this variation may be independentof tax shielding, debt ratios provide an inappropriate frameworkfor empirically examining the trade-off theory of capital structure.     

Optimality of project financing: Theory and empirical implications in finance and accounting

During the 1980s a fairly active market developed in the private placement of limited recourse project financing. Although this form of financing is gaining in importance, we know very little about it. This article presents a theoretical analysis of project financing. In the model of the firm presented, outstanding risky debt gives rise to agency costs of underinvestment that are offset by the benefit of debt-related tax shields. The tradeoff specifies the optimal leverage for a firm. Within this framework, we consider the optimality of financing a new project with a nonrecourse project financing arrangement. We derive implications for 1) the characteristics of a new venture that will be project financed, 2) the wealth gains from project financing over that of financing with straight debt, and 3) the optimal allocation of debt across the different assets (the sponsor firm vs. the new venture). It is shown that a project financing arrangement, where the debt is optimally allocated to the sponsor firm and the new venture, increases value by reducing agency costs and increasing the value of tax shields (compared to the case of straight debt financing). The optimal allocation of debt in project financing involves assigning to the sponsor firm and the new venture debt levels equal to their individual optimal capital structures. Several testable empirical implications in finance and accounting are developed.     

Do Firms Hedge in Response to Tax Incentives?

There are two tax incentives for corporations to hedge: to increase debt capacity and interest tax deductions, and to reduce expected tax liability if the tax function is convex. We test whether these incentives affect the extent of corporate hedging with derivatives. Using an explicit measure of tax function convexity, we find no evidence that firms hedge in response to tax convexity. Our analysis does, however, indicate that firms hedge to increase debt capacity, with increased tax benefits averaging 1.1 percent of firm value. Our results also indicate that firms hedge because of expected financial distress costs and firm size.     

Taxes, Financing Decisions, and Firm Value

We use cross-sectional regressions to study how a firm's value is related to dividends and debt. With a good control for profitability, the regressions can measure how the taxation of dividends and debt affects firm value. Simple tax hypotheses say that value is negatively related to dividends and positively related to debt. We find the opposite. We infer that dividends and debt convey information about profitability (expected net cash flows) missed by a wide range of control variables. This information about profitability obscures any tax effects of financing decisions.     

Inside debt and firm risk-taking: Evidence from the UK pension reform

This paper provides new evidence on the relation between CEO inside debt and firm risk-taking by exploiting the change in the tax treatment of UK pensions following two pension amendments. The 2006 pension reform introduces the annual and lifetime allowance for UK pension schemes, significantly increasing income taxes associated with CEO inside debt. The 2011 allowance cut, which substantially reduces the annual allowance introduced in 2006, further increases income taxes on inside debt. We find that CEO inside debt, in the form of executive pensions declines after the 2006 reform while cash-in-lieu increases significantly. This effect is more severe after the 2011 allowance cut than the 2006 pension reform. UK firms appear to substitute away from pensions towards cash-in-lieu, where income taxes are less punishing. If the association between CEO inside debt and firm risk-taking is causal, we should observe a change of risk-taking after the decline of inside debt. Our results, which exploit the exogenous nature of the reforms, show that the decline of CEO pensions does not lead to any change in firm risk-taking. This result suggests that no causal relationship exists between CEO inside debt and firm risk-taking. Our results extend the inside debt literature, where empirical evidence is mainly documented in the US. Contrary to findings in the US, our evidence suggests that the use of CEO inside debt is motivated to minimise income tax rather than a tool to moderate firm risk.     

Debt, taxes, and international equilibrium

This paper employs an extended Miller model to analyze capital structure decisions of individual firms in a two-country setting. Miller equilibria are generally not consistent with an international equilibrium if the tax subsidy of debt differs across countries. The most obvious reason for differential tax subsidies is differences between national corporate tax rates. We also identify differential tax subsidies of debt if inflation rates differ across countries. For both cases we examine the adjustment process from national equilibria to an international equilibrium without and with barriers to international investment. We derive the relationship between the equilibrium yields on debt and equity in the two countries and discuss the Fisher hypothesis that real returns do not depend upon inflation in a two-country Miller world.