Taxes and Capital Structure Review of Literature

Hennessy A. Christopher and Toni M. Whited (2005) argued that traditional formulations of the financing decision place the firm at date zero with no cash on hand. Such firms are at the debt versus external equity financing margin, since each dollar of debt replaces a dollar of external equity. The problem with the traditional approach is that corporations do not spend their lives at date zero. Rather, they evolve in a stochastic way, finding themselves at different financing margins over time.

MM (1963, p. 442) stated “The existence of a tax advantage for debt financing does not necessarily mean that corporation should at all times seek to use the maximum possible amount of debt, for one thing, other forms of financing, notably retained earnings, may in some circumstances be cheaper still when the tax status of investors under the personal income tax is taken into account. More important, there are, as we pointed out, limitations imposed by lends which are not fully comprehended within the framework of static equilibrium models, either our own or those of the traditional variety.”

Hennessy A. Christopher and Toni M. Whited (2005) expressed that dynamic model that MM had in mind never been worked out. They address the seeming anomalies by solving and simulating a dynamic model of investment and financing under uncertainty, where firm faces a realistic tax environment, small equity flotation costs, and financial distress costs. The firm maximizes its value by making two interrelated decisions: How much to invest and whether to finance this investment internally, externally.  The firm can either borrow or save and can be in one of three equity regimes (positive distributions, zero distributions, or equity issuance. The firm is forward looking, making current investment and financing decisions in anticipation of future financing needs.

Hennessy A. Christopher and Toni M. Whited (2005) use an illustration to explain this concept, assume a firm that realized a high profit shock last period, with internal cash exceeding desired investment. Rather than choosing between debt and external equity, this firm must choose between retention and distribution of the excess funds. Note also that each dollar of debt issued by this high liquidity firm would serve to increase the distribution to shareholders, rather than replacing external equity. They suggest that high liquidity firms are more likely to be at the latter financing margin, they issue less debt. They concluded that given the importance of a corporation’s endogenous financing margin, characterization of how the tax system influences the financial and investment policies of a rational firm necessitates a forward looking dynamic framework.

Hennessy A. Christopher and Toni M. Whited (2005) show theoretically and via model simulations that there is no target leverage ratio, firms can be savers or heavily levered, leverage is path dependent and exhibits hysteresis, leverage is decreasing in lagged cash flow and profitability, and leverage varies negatively with an external finance weighted average Q ratio. They also show that taxation does not have a second order effect on leverage decisions. Indeed, even in the presence of a premium on external equity, they find that variations in tax parameters have more power to explain anomalies than this premium. The key difference between their theory and its predecessors are the simple ideas that firms make leverage decisions jointly with current investment decisions and that this joint decision depends strongly on the current and anticipated financing margins.

Miller (1977) perpetual tax shield formula has served as one of the major reference for those evaluating whether taxes can explain observed financing patterns. This formula is a cornerstone of the static trade off theory, which posits that firms weigh the tax benefits of debt against costs associated with financial distress and bankruptcy. Graham (2000) found that “Paradoxically, large, liquid, profitable firms with low expected distress costs use debt conservatively”. Graham (2000) result is consistent with Miller formula. 

Myres (2001) discussed in his paper that firm can take advantage of tax shield provided firm is profitable but firm may not always be profitable, so the average effective future tax rate is less than the statutory rate. Second, debt is not permanent and fixed. Investors today cannot know the size and duration of future interest tax shields. Debt capacity depends purely on the future profitability and value of the firm, it may be able to increase borrowing if it does well, or be forced to pay down debt if it does poorly. The future interest tax shields flowing to investors are therefore risky.  Titman and Wessels (1988) discussed in their paper by referring to DeAngelo and Masulis that their model of optimal capital structure included the impact of corporate taxes, personal taxes, and non debt related corporate tax shields. They argue that tax deductions for depreciation and investment tax credits are substitutes for the tax benefits of debt financing. As a result, firms with large non debt tax shields relative to their expected cash flow include less debt in their capital structure. Titman and Wessels (1988) result of non debt tax shield is insignificant and they concluded that non debt tax shield is not playing role in the decision of debt financing.

In some studies; actual debt ratios consistently find that the most profitable companies in a given industry tend to borrow the least (Myers, 2001; Titman and Wessels, 1988; Friend and Lang, 1988; Fama and French, 2002). High profits mean low debt, and vice versa. But if managers can take advantage of valuable interest tax shields, as the tradeoff theory predicts, we should observe exactly the opposite relationship. High profitability means that the firm has more taxable income to shield, so that means the firm can service more debt without risking financial distress. If the theory is right, then a value maximizing firm should never pass up interest tax shields when the possibility of bankruptcy cost is low.

The tradeoff theory cannot account for the correlation between high profitability and low debt ratios. It’s not fair to claim that managers are strongly conservative or not value maximizing. This objection fails because we have seen great innovation in financing tactics and schemes which actually shows that managers pay attention to taxes. Some studies have appeared but none gives conclusive support for the tradeoff theory.

Myers (1984) concluded, after reviewing the empirical work, that there was no study which clearly shows that a firm's tax status has any material effect on its debt policy. MacKie-Mason (1990) estimated a probit model for companies issuing debt or equity securities. He predicted that companies with low marginal tax rates would be more likely to issue equity, compared to more profitable companies facing the full statutory tax rate. Graham (1996) also finds evidence that changes in long-term debt are positively and significantly related to the firm's effective marginal tax rate. Again this shows that taxes affect financing decisions, at least at the tactical level. Fama and French (1998), despite an extensive statistical search, could find no evidence that interest tax shields contributed to the market value of the firm.

MacKie-Mason's (1990) result is somehow consistent with the tradeoff theory, because it shows that the taxpaying firms favor debt. However it is also consistent with a Miller (1977) equilibrium in which the value of corporate interest tax shields is entirely offset by the low effective tax rate on capital gains. In this case, a firm facing a low tax rate would also use equity, because investors pay more taxes on debt interest than on equity income. Thus, the researcher cannot conclude from MacKie-Mason's results that interest tax shields make a significant contribution to the market value of the firm (Myers, 2001).

The tradeoff theory rationalizes moderate debt ratios. It is consistent with a fact that companies with relatively safe, tangible assets tend to borrow more than companies with risky, intangible assets. Tradeoff theory not only covers tax benefit of debt but also consider bankruptcy cost which is discussed here.