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Can tax convexity be ignored in corporate financing decisions?

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  • Sarkar, Sudipto
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    Abstract

    The standard modeling practice in corporate finance has been to assume a linear tax schedule. This paper extends the structural contingent-claim model of corporate finance to incorporate a more realistic convex tax schedule. It is shown that tax convexity raises the optimal default boundary and thus increases the likelihood of default, and also reduces the optimal leverage ratio. While the former effect seems insignificant in general, the effect of tax convexity on the optimal leverage ratio can be quantitatively significant. We conclude that tax convexity should not be ignored in corporate financing decisions, and theoretical models should use a convex tax schedule instead of a linear one. Thus, the short answer to the question in the title is "No".

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 32 (2008)
    Issue (Month): 7 (July)
    Pages: 1310-1321

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    Handle: RePEc:eee:jbfina:v:32:y:2008:i:7:p:1310-1321

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    Web page: http://www.elsevier.com/locate/jbf

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    Cited by:
    1. Andreas Andrikopoulos, 2012. "The Capital Structure Choice and the Consumption Tax," European Research Studies Journal, European Research Studies Journal, vol. 0(1), pages 3-22.
    2. Kit Wong, 2010. "On the neutrality of debt in investment intensity," Annals of Finance, Springer, vol. 6(3), pages 335-356, July.
    3. Wong, Kit Pong, 2009. "Progressive taxation, tax exemption, and corporate liquidation policy," Economic Modelling, Elsevier, vol. 26(2), pages 295-299, March.
    4. Adrian Lei & Martin Yick & Keith Lam, 2013. "Does tax convexity matter for risk? A dynamic study of tax asymmetry and equity beta," Review of Quantitative Finance and Accounting, Springer, vol. 41(1), pages 131-147, July.
    5. Nishihara, Michi & Shibata, Takashi, 2014. "Preemption, leverage, and financing constraints," Review of Financial Economics, Elsevier, vol. 23(2), pages 75-89.

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