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.

[1]  Merton H. Miller.  Financial Markets and Economic Growth , 1998 .

[2]  S. Myers,et al.  The Paradox of Liquidity , 1995 .

[3]  M. C. Jensen,et al.  Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers , 1999 .

[4]  Stewart C. Myers,et al.  Testing static tradeoff against pecking order models of capital structure 1 , 1999 .

[5]  Jeffrey K. MacKie-Mason,et al.  Effects of the Tax Reform Act of 1986 on Corporate Financial Policy and Organizational Form , 1990 .

[6]  S. Myers.  STILL SEARCHING FOR OPTIMAL CAPITAL STRUCTURE , 1993 .

[7]  J. Graham,et al.  Debt and the Marginal Tax Rate , 1996 .

[8]  René M. Stulz,et al.  Timing, investment opportunities, managerial discretion, and the security issue decision , 1996 .

[9]  Edwin J. Elton,et al.  Marginal Stockholder Tax Rates and the Clientele Effect , 1970 .

[10]  René M. Stulz,et al.  Managerial discretion and optimal financing policies , 1990 .

[11]  J. Skelton.  Banks, firms and the relative pricing of tax-exempt and taxable bonds , 1983 .

[12]  J. Graham,et al.  MEASURING CORPORATE TAX RATES AND TAX INCENTIVES: A NEW APPROACH , 1998 .

[13]  Alex Kane,et al.  How Big is the Tax Advantage to Debt? , 1984 .

[14]  René M. Stulz,et al.  The Determinants and Implications of Corporate Cash Holdings , 1997 .

[15]  G. Phillips,et al.  Increased debt and industry product markets an empirical analysis , 1995 .

[16]  Stephen W. Pruitt,et al.  A Simple Approximation of Tobin's Q , 1994 .

[17]  J. Graham.  Do Personal Taxes Affect Corporate Financing Decisions? , 1998 .

[18]  E. Fama,et al.  Taxes, Financing Decisions, and Firm Value , 1997 .

[19]  J. Graham,et al.  Debt, Leases, Taxes and the Endogeneity of Corporate Tax Status , 1997 .

[20]  E. Altman.  Measuring Corporate Bond Mortality and Performance , 1989 .

[21]  Sheridan Titman,et al.  The Determinants of Capital Structure Choice , 1988 .

[22]  Judith A. Chevalier,et al.  Do LBO Supermarkets Charge More? An Empirical Analysis of the Effects of LBOs on Supermarket Pricing , 1995 .

[23]  J. Chalmers.  Default Risk Cannot Explain the Muni Puzzle: Evidence from Municipal Bonds that are Secured by U.S. Treasury Obligations , 1998 .

[24]  Merton H. Miller,et al.  DEBT AND TAXES , 1977 .

[25]  Richard S. Ruback,et al.  The Valuation of Cash Flow Forecasts: An Empirical Analysis , 1994 .

[26]  P. Fortune.  MUNICIPAL BOND YIELDS: WHOSE TAX RATES MATTER? , 1988, National Tax Journal.

[27]  Robert Heinkel,et al.  Dynamic Capital Structure Choice: Theory and Tests , 1989 .

[28]  Steven A. Sharpe,et al.  Capital market imperfections and the incentive to lease , 1995 .

[29]  Kenneth A. Froot,et al.  Interest Allocation Rules, Financing Patterns, and the Operations of U.S. Multinationals , 1994 .

[30]  Merton H. Miller.  The Cost of Capital, Corporation Finance and the Theory of Investment , 1958 .

[31]  M. Weisbach,et al.  Measuring investment distortions arising from stockholder-bondholder conflicts , 1999 .

[32]  J. H. Collins,et al.  Foreign Tax Credit Limitations And Preferred Stock Issuances , 1992 .

[33]  Nengjiu Ju,et al.  An Ebit-Based Model of Dynamic Capital Structure , 2001 .

[34]  Simon Benninga,et al.  Corporate Finance: A Valuation Approach , 1996 .

[35]  J. Poterba.  The Rate of Return to Corporate Capital and Factor Shares: New Estimatesusing Revised National Income Accounts and Capital Stock Data , 1998 .

[36]  R. Green,et al.  A Simple Model of the Taxable and Tax-Exempt Yield Curves , 1993 .

[37]  M. Feldstein,et al.  INFLATION AND THE TAXATION OF CAPITAL INCOME IN THE CORPORATE SECTOR , 1979, National Tax Journal.

[38]  Ronald W. Masulis,et al.  Optimal Capital Structure Under Corporate and Personal Taxation , 1980 .

[39]  Robert A. Taggart,et al.  Consistent Valuation and Cost of Capital Expressions with Corporate and Personal Taxes , 1989 .

[40]  A. Auerbach.  Stockholder Tax Rates and Firm Attributes , 1981 .

[41]  P. Fortune.  Do municipal bond yields forecast tax policy , 1996 .

[42]  Campbell R. Harvey,et al.  The Theory and Practice of Corporate Finance: Evidence from the Field , 1999 .

[43]  D. Yermack,et al.  Managerial Entrenchment and Capital Structure Decisions , 1995 .

[44]  John R. Graham,et al.  Proxies for the corporate marginal tax rate , 1996 .

[45]  F. Modigliani,et al.  CORPORATE INCOME TAXES AND THE COST OF CAPITAL: A CORRECTION , 1963 .

[46]  Edward I. Altman,et al.  FINANCIAL RATIOS, DISCRIMINANT ANALYSIS AND THE PREDICTION OF CORPORATE BANKRUPTCY , 1968 .

[47]  S. Myers.  Determinants of corporate borrowing , 1977 .

[48]  J. Poterba.  Tax Reform and the Market for Tax-Exempt Debt , 1989 .

[49]  Sheridan Titman,et al.  The effect of capital structure on a firm's liquidation decision☆ , 1984 .

[50]  A. Barnea,et al.  The Value of the Tax Subsidy on Risky Debt , 1985 .

[51]  J. Scholz.  A direct examination of the dividend clientele hypothesis , 1992 .

[52]  J. Graham,et al.  How Big are the Tax Benefits of Debt? , 1998 .

[53]  Jeffrey K. MacKie-Mason.  Do Taxes Affect Corporate Financing Decisions? , 1988 .

[54]  R. Green,et al.  The Personal-Tax Advantages of Equity , 1999 .

[55]  J. A. Miles,et al.  Reformulating Tax Shield Valuation: A Note , 1985 .