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How Big Is the Tax Advantage to Debt?

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  • Kane, Alex
  • Marcus, Alan J
  • McDonald, Robert L

Abstract

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 junip 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.
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Suggested Citation

  • Kane, Alex & Marcus, Alan J & McDonald, Robert L, 1984. " How Big Is the Tax Advantage to Debt?," Journal of Finance, American Finance Association, vol. 39(3), pages 841-853, July.
  • Handle: RePEc:bla:jfinan:v:39:y:1984:i:3:p:841-53
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    References listed on IDEAS

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    9. Stephen A. Ross, 1977. "The Determination of Financial Structure: The Incentive-Signalling Approach," Bell Journal of Economics, The RAND Corporation, vol. 8(1), pages 23-40, Spring.
    10. Kane, Alex & Marcus, Alan J. & McDonald, Robert L., 1985. "Debt Policy and the Rate of Return Premium to Leverage," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(04), pages 479-499, December.
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    15. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
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    Cited by:

    1. Strebulaev, Ilya A. & Whited, Toni M., 2012. "Dynamic Models and Structural Estimation in Corporate Finance," Foundations and Trends(R) in Finance, now publishers, vol. 6(1–2), pages 1-163, November.
    2. Gabriela Brendea, 2014. "Financing Behavior of Romanian Listed Firms in Adjusting to the Target Capital Structure," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 64(4), pages 312-329, September.
    3. repec:oup:rcorpf:v:4:y:2015:i:1:p:1-42. is not listed on IDEAS
    4. Kristoffer J. Glover & Gerhard Hambusch, 2014. "The trade-off theory revisited: on the effect of operating leverage," International Journal of Managerial Finance, Emerald Group Publishing, vol. 10(1), pages 2-22, January.
    5. Hayne E. Leland, 1998. "Agency Costs, Risk Management, and Capital Structure," Journal of Finance, American Finance Association, vol. 53(4), pages 1213-1243, August.
    6. Ilya A. Strebulaev, 2007. "Do Tests of Capital Structure Theory Mean What They Say?," Journal of Finance, American Finance Association, vol. 62(4), pages 1747-1787, August.
    7. repec:gam:jijfss:v:6:y:2018:i:2:p:41-:d:140401 is not listed on IDEAS
    8. Nengjiu Ju & Robert Parrino & Allen M. Poteshman & Michael S. Weisbach, 2002. "Horses and Rabbits? Optimal Dynamic Capital Structure from Shareholder and Manager Perspectives," NBER Working Papers 9327, National Bureau of Economic Research, Inc.
    9. Moyen, Nathalie, 2007. "How big is the debt overhang problem?," Journal of Economic Dynamics and Control, Elsevier, vol. 31(2), pages 433-472, February.
    10. Mehdi Elhaei Sahar & Seyed Ali Vaez, 2013. "Information Asymmetry and Financing Decisions: Evidence from Iran Stock Exchange," International Journal of Academic Research in Accounting, Finance and Management Sciences, Human Resource Management Academic Research Society, International Journal of Academic Research in Accounting, Finance and Management Sciences, vol. 3(3), pages 105-110, July.
    11. Pierre Mella-Barral, 1996. "The Dynamics of Corporate Debt forgiveness and Contract Renegotiation," FMG Discussion Papers dp230, Financial Markets Group.
    12. Danis, András & Rettl, Daniel A. & Whited, Toni M., 2014. "Refinancing, profitability, and capital structure," Journal of Financial Economics, Elsevier, vol. 114(3), pages 424-443.
    13. Andrea Gamba & Gordon A. Sick & Carmen Aranda León, 2008. "Investment under Uncertainty, Debt and Taxes," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 37(1), pages 31-58, February.
    14. Sinha, Pankaj & Bansal, Vishakha, 2013. "Capital structure puzzle: the interrelationship between leverage, taxes and other micro economic factors," MPRA Paper 49878, University Library of Munich, Germany, revised 17 Sep 2013.
    15. DeAngelo, Harry & DeAngelo, Linda & Whited, Toni M., 2011. "Capital structure dynamics and transitory debt," Journal of Financial Economics, Elsevier, vol. 99(2), pages 235-261, February.
    16. Martin Dòzsa & Karel Janda, 2015. "Corporate asset pricing models and debt contracts," CAMA Working Papers 2015-33, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    17. Kane, Alex & Marcus, Alan J. & McDonald, Robert L., 1985. "Debt Policy and the Rate of Return Premium to Leverage," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(04), pages 479-499, December.
    18. repec:eee:rujoec:v:3:y:2017:i:4:p:379-410 is not listed on IDEAS
    19. Martin Dózsa & Jakub Seidler, 2012. "Debt Contracts and Stochastic Default Barrier," Working Papers IES 2012/17, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised Jun 2012.
    20. Popova, Svetlana & Karlova, Nataliya & Ponomarenko, Alexey & Deryugina, Elena, 2017. "Analysis of the debt burden in Russian economy sectors," Russian Journal of Economics, Elsevier, vol. 3(4), pages 379-410.
    21. Pascal Francois, 2006. "Tax loss carry-forwards and optimal leverage," Applied Financial Economics, Taylor & Francis Journals, vol. 16(14), pages 1075-1083.
    22. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.

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