Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice

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JWBT436-c02 JWBT436-Baker March 4, 2011 7:14 Printer Name: Hamilton

FACTORS AFFECTING CAPITAL STRUCTURE DECISIONS 27

Tax Considerations

Firms will exploit the tax deductibility of interest payments to reduce their tax

payments, and hence the trade-off theory predicts that firms tend to issue more

debt when corporate tax rates are higher. However, firms with other tax shields,

such as net operating loss carry-forwards, depreciation expenses, and investment

tax credits, have less need to exploit the debt tax shield. Ross (1985) argues that if

such firms issue excessive debt, they may become “tax-exhausted” in the sense that

they are unable to use all their potential tax shields. Debt is then “crowded out,”

and the incentive to use debt financing diminishes as nondebt tax shields increase.

Accordingly, in the framework of the trade-off theory, one would expect a negative

relationship between leverage and nondebt tax shields. In contrast, Scott (1977)

and Moore (1986) argue that firms with substantial nondebt tax shields should

also have considerable collateral assets that can be used to secure debt. Secured

debt is less risky than unsecured debt, and hence one could also hypothesize a

positive relationship between leverage and nondebt tax shields.

The impact of taxes on leverage can be measured using different variables.

Examples are the top statutory tax rate, the ratio of the net operating loss carry-

forward to assets, the ratio of depreciation expense, and the ratio of investment ...