Working Paper: NBER ID: w1286
Authors: Alex Kane; Alan J. Marcus; Robert L. McDonald
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.
Keywords: Tax advantage; Debt; Bankruptcy costs; Corporate finance
JEL Codes: G32; H25
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| bankruptcy costs (K35) | existence of different capital structures (G32) |
| asset value volatility (G19) | firm capital structure (G32) |
| tax advantage to debt (G32) | firm's leverage decision (G32) |
| tax advantage-bankruptcy cost tradeoff (G33) | observed leverage patterns (G32) |