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Can tax convexity be ignored in corporate financing decisions?

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  • Sarkar, Sudipto

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".

Suggested Citation

  • Sarkar, Sudipto, 2008. "Can tax convexity be ignored in corporate financing decisions?," Journal of Banking & Finance, Elsevier, vol. 32(7), pages 1310-1321, July.
  • Handle: RePEc:eee:jbfina:v:32:y:2008:i:7:p:1310-1321
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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. Nishihara, Michi & Shibata, Takashi, 2014. "Preemption, leverage, and financing constraints," Review of Financial Economics, Elsevier, vol. 23(2), pages 75-89.
    3. Nishihara, Michi & Shibata, Takashi, 2016. "Asset sale, debt restructuring, and liquidation," Journal of Economic Dynamics and Control, Elsevier, vol. 67(C), pages 73-92.
    4. Wong, Kit Pong, 2009. "Progressive taxation, tax exemption, and corporate liquidation policy," Economic Modelling, Elsevier, vol. 26(2), pages 295-299, March.
    5. repec:spr:schmbr:v:70:y:2018:i:1:d:10.1007_s41464-017-0031-1 is not listed on IDEAS
    6. Sami Attaoui, 2016. "Capital Structure And Tax Convexity When The Maturity Of Debt Is Finite," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(01), pages 1-20, February.
    7. 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.
    8. Kit Wong, 2010. "On the neutrality of debt in investment intensity," Annals of Finance, Springer, vol. 6(3), pages 335-356, July.

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