14.4How Corporate Taxes Affect the Capital Structure Choice

Financial managers spend a great deal of time making decisions about their firms’cap-

ital structures. In addition, stock prices react dramatically when firms make major

changes in their capital structures.⁶

This suggests that it probably would be unwise to

stick with the conclusion that the capital structure decision is irrelevant.

The apparent relevance of the capital structure decision suggests that some of the

assumptions underlying the Modigliani-Miller Theorem are unrealistic and that relaxing

them may have important implications for the firm’s capital structure choice. The most

obviously unrealistic assumption is that of no taxes. Taxes have a major effect on the cash

flows of firms and, as a result, strongly influence their capital structure decisions. Indeed,

a recent study of 392 CFOs by Graham and Harvey (2001) found that 45% surveyed

agreed that tax considerations played either an important or very important role in their

capital structure choices. The preceding two sections indicated that, in the absence of

taxes, a firm’s value does not depend on its capital structure. It follows that, in the absence

of other market frictions, minimizing the amount paid in taxes maximizes the cash flows

to the firm’s equity holders and debt holders, thereby maximizing the firm’s total value.

In the U.S., the existence of corporate taxes favors debt financing. This is because,

in the U.S., interest is a tax-deductible corporate expense. However, since dividends

are viewed as distributions of profits rather than expenses of doing business, they are

not tax deductible.⁷

Howard Hughes’s perceptive analysis of the tax benefits of debt financing,

described in the chapter’s opening vignette, predated the academic discussion of debt

and taxes by several years. This section explores the types of tax benefits he mentioned

in more detail, specifically considering situations in which there are (1) corporate taxes,

(2) tax-deductible interest expenses, and (3) no personal taxes. In the next section and

in Chapter 15 we will explore the effects of personal taxes.

How Debt Affects After-Tax Cash Flows

If the corporate tax rate is T,a firm with pretax cash flows of X˜,which we will assume

c

for simplicity is EBIT, and interest payments of rDhas taxable income of X˜rD

DD

and pays a corporate tax of (˜rD)T.Since interest expense is tax deductible, a

X

Dc

firm can reduce its tax liabilities and thus increase the amount it distributes to its secu-

rity holders by issuing additional debt. Therefore, in the absence of personal taxes,

transaction costs, and bankruptcy costs, and holding the pretax cash flow generated by

the firm constant, the value-maximizing capital structure includes enough debt to elim-

inate the firm’s tax liabilities.

⁵Studies by Asquith and Wizman (1990) and Warga and Welch (1993) indicate that bondholders lost

money in a number of other leveraged buyouts as well.

6

Stock price reactions to corporate events like capital structure changes are discussed in Chapter 19.

⁷Afirm can carry back the net losses in its current year as far as two years. When there is not

enough income in the previous two years to allow the loss carryback, the firm can carry forward those

losses for up to 20 years to offset future taxable profits. Hence, the corporate tax advantage of debt

financing applies even to firms that are temporarily unprofitable, although the debt tax shield is used less

efficiently if it must be carried forward.

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510Part IVCapital Structure

To examine how debt affects firm values in the presence of corporate taxes, assume

that the firm is financed with a combination of equity and a risk-free perpetuity bond

(see Chapter 2), which pays interest at a fixed rate of rforever. The year tsum of the

D

after-(corporate) tax payments to its debt and equity holders is expressed in the fol-

lowing equation:

˜(X˜rD)(1T) rD	(14.1)
C
ttDcD

By rearranging terms, the firm’s cash flows to its debt and equity holders can be

expressed as the sum of the cash flows that the firm would have generated if it were

an all-equity firm—its unlevered cash flows—plus the additional cash flows it gener-

ates because of the tax gain from debt:

˜X˜(1T) rDT	(14.2)
C
ttcDc

How Debt Affects the Value of the Firm

As Chapter 13 showed, the value of the firm is the present value of the stream of future

cash flows generated by the unlevered cash flows and tax savings expressed in equation

(14.2). To determine how the value of the firm changes with a change in leverage, note

˜

that X(1 T) is the year tcash flow that would be achieved by an unlevered firm.

tc

˜(1T), X˜(1T), . . . ,

Therefore, the present value of this series of cash flows, X

1c2c

must equal the value of the firm had it been unlevered (V). In addition, recall that

U

with static perpetual debt the present value of the firm’s yearly tax savings rTDis

Dc

TD.This implies the following result:

c

Result	14.4	Assume that the pretax cash flows of the firm are unaffected by a change in a firm’s cap-
		ital structure, and that there are no transaction costs or opportunities for arbitrage. With cor-
		porate taxes at the rate T,but no personal taxes, the value of a levered firm with static
		c
		risk-free perpetual debt is the value of an otherwise equivalent unlevered firm plus the prod-
		uct of the corporate tax rate and the market value of the firm’s debt; that is

VV TD	(14.3)
LUc

As equation (14.3) illustrates, the value of the firm increases with leverage by the

amount TD,which is the tax gain to leverage.

c

To illustrate how tax-deductible debt can increase the cash flows to shareholders

as well as increase firm value, Example 14.3 recalculates the answer to Example 14.2,

assuming that there are corporate taxes.

Example 14.3:The Effect of Corporate Taxes on Cash Flows to Equity and

Debt Holders

Recall from Example 14.2 that Stanley Kowalski held 10 percent of the firm’s equity and that

the firm was increasing its debt level from $10,000 to $60,000.In this example the firm uses

perpetuity bonds instead of zero-coupon bonds for debt financing and retires $50,000 in

equity with the proceeds.

Compute Stanley’s cash flow (1) in the original low-leverage scenario and (2) in the high-

leverage scenario in which the investor attempts to undo the firm’s capital structure change

by selling $5,000 of his shares and using the proceeds to buy $5,000 in bonds.Assume

there is a corporate tax on earnings at a rate of T.

c

Answer:The cash flow to Stanley given the initial low level of debt is

˜.1[˜r$10,000](1T)

CX

low levDc

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Chapter 14

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511

A leverage increase of $50,000 that is offset by a change in Stanley’s portfolio will now

yield cash flows to Stanley of

˜.1[X˜r$60,000](1T)] r$5,000

C

high levDcD

.1[˜r$10,000](1T) rT$5,000

X

DcDc

Afirm that increases its debt level by issuing, as in Example 14.3, an additional

$50,000 in bonds and buying back $50,000 in equity is doing its stockholders a favor.

In this case, a 10 percent equity investor in the firm, like Stanley, who sells $5,000 in

stock and uses the proceeds to buy $5,000 in bonds, increases his cash flow by

rT$5000 while restoring the rest of his portfolio to where it was before the firm

Dc

increased its leverage. This insight generalizes to every shareholder irrespective of his

percentage ownership in the firm, and to every debt issuance, with more debt generat-

ing a larger benefit to the shareholder. This implies the following result:

Result 14.5

Assume that the pretax cash flows of the firm are unaffected by a change in a firm’s cap-ital structure, and that there are no transaction costs or opportunities for arbitrage. With cor-porate taxes but no personal taxes, a firm’s optimal capital structure will include enoughdebt to completely eliminate the firm’s tax liabilities.

Example 14.4 illustrates the tax gains associated with leverage for a hypothetical

leverage increase by RJR Nabisco in 1987, before its leveraged buyout.

Example 14.4:Recapitalizing RJR Nabisco

In 1987, RJR Nabisco earned $2,304 million before interest and taxes, out of which $488

million was paid out in interest and $735 million was paid out in taxes.Suppose that RJR

chose to recapitalize by distributing to its shareholders$5 billion in 9.4 percent notes, requir-

ing $470 million in annual interest payments.Assuming that the investment choice and the

pretax cash flows (and EBIT) of the firm are unchanged, how would this additional $470 mil-

lion affect the cash flows to a tax-exempt shareholder?

Answer:From RJR’s annual report, we compute the following:

	Recapitalization
1987 (in $millions)	(in $millions)

EBIT	$2,304	$2,304
Net interest expenses	488	958
EBT	1,816	1,346
Taxes (rate 40.5%)	735	545
Net income	1,081	801
Gain from extraordinary item	128	128
Net profits (a)	1,209	929
Net investment (b)	739	739
Dividends [(a) (b)]	470	190
CF to shareholders (from stock and bonds)	470	660
	($1.88/share)	($2.64/share)

The difference in the cash flows between the two scenarios, $190 million ($660 $470)

equals the tax savings from the debt, .405

.094

$5 billion.

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512	Part IVCapital Structure

14.5	How Personal Taxes Affect Capital Structure

Atax-exempt shareholder, such as a pension fund, is indifferent about whether the cash

flows of a firm come in the form of interest on debt, dividends on equity, or capital

gains on equity as long as the form of the payment does not affect the magnitude of

the payment. Since the total cash flows to the equity and debt holders of firms are

larger when cash flows are paid out in the form of debt interest payments instead of

retained or paid as dividends, tax-exempt shareholders will prefer firms to have high

leverage. However, investors who pay personal taxes prefer to receive income in the

form of capital gains because capital gains can always be deferred and, in many coun-

tries, are taxed at lower rates than interest or dividend income.⁸As a result, the aver-

age tax rate on stock income T,which generally has a capital gains component, is less

E

than the average tax rate on debt income T,which is taxed as ordinary income; that

D

is, TT.This preference for capital gains income can lead some taxable share-

ED

holders to prefer firms with less leverage.

The Effect of Personal Taxes on Debt and Equity Rates of Return

We first examine how personal taxes affect the expected rates of return required to

induce investors to hold debt securities instead of equity securities. In general, debt is

less risky than equity and thus requires a lower expected rate of return. To simplify this

analysis, we assume that debt is risk-free with a promised coupon and return of r.We

D

also assume that investors are risk neutral, so that the expected return of equity, r,

E

which more generally can be viewed as a pretax zero-beta expected return, differs from

ronly because of taxes. (Our results apply to positive beta equity with risk-averse

D

investors if we first adjust expected returns downward by their risk premiums in the

formulas we present here.)

Which Investors PreferDebt and Which PreferEquity.In the absence of taxes

and other market frictions, the expected return of zero-beta equity equals the return on

riskless debt (see Chapter 5). With personal taxes, however, it is necessary to account

for the fact that the returns to equity, which often come in the form of capital gains,

are generally taxed less heavily than the returns to debt. To compensate taxable

investors for its relative tax disadvantage, the pretax return on debt should exceed the

pretax zero-beta expected return on equity.

This pretax return difference leads tax-exempt investors to prefer debt to equity.

However, if the return difference is not too large, investors in the highest tax brackets

should prefer equity to debt. There will also be investors who are indifferent between

holding debt and equity. The personal tax rates on debt and equity of these indifferent

investors satisfy the following condition:

r(1T)r(1T)	(14.4)
DDEE

⁸Capital gains tax rates change from year to year as well as from country to country. For example,

Hong Kong and Taiwan have no tax on capital gains. In the United States, the tax rate on capital gains

has been as low as 40 percent of the ordinary income tax rate; in 1999 the highest federal tax rate on

capital gains income was 20 percent while the highest rate on dividend and interest income was 39.6

percent. There also are state taxes on capital gains and interest and dividend income which could affect

the attractiveness of debt and equity financing. State taxes differ from state to state and will not be

considered in this text.

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Chapter 14

How Taxes Affect Financing Choices

513

so that the after-tax expected return is the same for each security. In general, if

r(1T) r(1T)for a particular investor incurring tax rates of Tand T—

DDEEDE

that is, the after-tax return to debt exceeds the after-tax expected return to equity—the

investor will prefer debt to equity. If the inequality is reversed, the investor will prefer

equity to debt.

Example 14.5:Personal Tax Preferences forHolding Debt versus

EquitySecurities

Assume that the expected rates of return on debt and zero-beta equity securities are as follows:

r7%

D

r6%

E

John has a tax rate on debt income of 40 percent, and George has a tax rate on debt income

of 20 percent.Both individuals are subject to the same marginal tax rate on equity income,

the capital gains rate, which is 20 percent.Which investor prefers the debt security and which

prefers the equity?

Answer:For John, the after-tax rate of return on debt is 4.2 percent, which is less than

his after-tax expected rate of return on zero-beta equity, which is 4.8 percent.However,

George receives an after-tax rate of return on debt of 5.6 percent, which exceeds his after-

tax rate of return on the equity security of 4.8 percent.Hence, John prefers the equity invest-

ment, and George prefers the debt investment.

The Analysis When Investors Have Identical Tax Rates.To understand how per-

sonal taxes affect the choice between issuing debt and issuing equity, consider the total

cash flows distributed to the firm’s debt and equity investors. For simplicity, assume

that the personal tax rates, Tand T, do not differ across investors.The after-tax cash

DE

flow Cthat these investors receive is determined by corporate taxes, personal taxes,

and the way in which the firm is financed. Exhibit 14.4 illustrates this as a stream of

cash that starts with all the firm’s realized pretax cash flows Xand branches out into

smaller streams that reflect the cash distributed to debt and equity holders, and to the

government in the form of taxes. To keep this illustration simple, Exhibit 14.4 assumes

that the firm pays out all its earnings and that its earnings before interest and taxes

(EBIT) exceed its promised interest payment, rD.

D

As Exhibit 14.4 illustrates, some of the cash, rD,is diverted into a branch of the

D

stream labeled “Payment to debt holders.” This branch of the stream reaches a fork

where some of the cash flows go to the government in the form of personal taxes on

the debt interest payments while the rest goes to the debt holders as an after-tax return.

The upper branch of the stream carries the pretax cash that flows to the equity hold-

ers. Part of this cash, (XrD)T,is diverted to the government in the form of cor-

Dc

porate taxes. The remainder of the firm’s cash flows, (XrD)(1 T), flows to the

Dc

firm’s equity holders, where (XrD)(1 T)Tis diverted to the branch labeled “Per-

DcE

sonal taxes on equity income,” with the rest going to equity holders as an after-tax return.

By summing the branches labeled after-tax return to debt holders (bottom left) and

after-tax return to equity holders (top right), we derive the total after-tax cash flow

stream flowing to the debt and equity holders:

C(XrD)(1 T)(1 T) rD(1 T)	(14.5a)
DcEDD

By rearranging terms, equation (14.5a) can be rewritten as:

CX(1 T)(1 T) rD[(1 T) (1 T)(1 T)](14.5b)

cEDDcE

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514Part IVCapital Structure

EXHIBIT14.4The Earnings Stream

		After-tax return
		to equity holders
	After corporate tax
		(X – r D D)(1 – T c )(1 – T E )
Earnings X	return to equity holders
	(X – r D D)(1 – T c )

Payment		Personal
to debt	Corporate	taxes
holders	taxes	on equity
		income
r D D	(X – r D D)T c
		(X – r D D)(1 – T c )T E

After-tax	Personal
return to	taxes
debt	on debt
holders	income

rD D(1 – T D )

rD DTD

where the last part of equation (14.5b), rD[(1 T) (1 T)(1 T)], represents

DDcE

the tax gain from leverage.

If the level of debt is permanently fixed, this tax gain can be viewed as a perpe-

tuity that accrues tax free to the firm’s debt and equity investors. It can be valued by

discounting the perpetuity payments at the after-(personal) tax rate on debt r(1 T)

DD

or, equivalently, at the after-(personal) tax return on equity (see equation (14.4)). The

present value of this perpetual stream of tax savings, obtained by dividing the right side

of equation (14.5b) by r(1 T), is TDwhere Tis given by

DDgg

T1 (1T)(1T)
cE	(14.6)
g1T
D

This generalizes Result 14.4 to include the effect of personal taxes.

Result	14.6	Assume that the pretax cash flows of the firm are unaffected by a change in a firm’s cap-
		ital structure, and that there are no transaction costs or opportunities for arbitrage. If
		investors all have personal tax rates on debt and equity income of Tand T,respectively,
		DE
		and if the corporate tax rate is T,then the value of a levered firm exceeds the value of an
		c
		otherwise equivalent unlevered firm by TD;that is
		g

VV TD,

LUg

where

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515

T1 ⁽¹T)(1T)

cE

^g1T

D

If Tin equation (14.6) is positive, firms will want to issue enough debt to elimi-

g

nate their tax liability; if Tis negative, firms will want to include no debt in their cap-

g

ital structures. Firms will be indifferent about their debt level if Tis zero, which is

g

the case when the following equality holds:

(1 T) (1 T)(1 T)	(14.7)
DcE

When this equality holds, each investor pays directly in personal taxes and indirectly

through the corporate tax the same amount in taxes for every pretax dollar that the firm

earns. This holds regardless of whether the earnings are distributed in the form of inter-

est payments to debt holders or accrue as capital gains to stockholders. Thus, the

investor and firm are indifferent about the capital structure choice the firm makes when

equation (14.7) holds. Note that this condition is different from the condition that makes

the same investor indifferent about holding debt versus equity, equation (14.4).

Example 14.6:The Effect of Corporate Taxes and Personal Taxes on the Tax

Gain from Leverage

In 2000 the maximum personal income tax rate was 40 percent, the maximum corporate tax

rate was 35 percent, and the rate on capital gains was 20 percent.Using these tax rates,

what is the tax gain from leverage?

Answer:From equation (14.6) T1 (.65

.8)/.6 .133.

g

The preceding example illustrates that personal taxes can significantly reduce the tax

advantage of debt. Twill be further reduced if one accounts for the fact that capital gains

g

can be deferred as well as taxed at a rate lower than the ordinary income tax rate.

As shown below, the zero-beta firm’s after-tax cost of capital will be the same for

debt and equity if equation (14.7) applies and if its investors are indifferent between

holding debt or equity. To prove this, combine equation (14.7), which provides the con-

dition for the firm to be indifferent between debt and equity, with equation (14.4), which

provides the condition for an investor to be indifferent between holding debt or equity,

to yield:

r(1T)r	(14.8)
DcE

The left-hand side of the equation is the firm’s after-(corporate) tax cost of debt;

the right-hand side its after-tax (and pretax) cost of equity. Thus, equation (14.8) states

that the after-tax cost of capital (adjusted for risk premiums) is the same for debt and

equity whenever the personal tax rates of the firm’s investors make them indifferent

about debt versus equity financing. Note, also, that if the left-hand side of equation

(14.8) is larger than the right-hand side, firms will find equity financing to be cheaper

(T0) if its investors are indifferent, and vice versa.

g

Capital Structure Choices When Taxable Earnings Can Be Negative

Up to this point we have assumed that firms can always utilize their interest tax shields.

However, this is unrealistic for many firms. Many firms have extremely low taxable

earnings even before taking into account the interest tax deduction. For example, many

start-up firms with substantial non-debt tax shields,such as R&D and depreciation

deductions, and very little current revenues, have no taxable earnings. This fact will

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516Part IVCapital Structure

allow us to develop a theory of optimal capital structure, based solely on taxes, in which

different firms, each with “indifferent investors” as discussed above, have different opti-

mal mixes of debt and equity financing.

Since firms with low taxable earnings will not always be able to take advantage

of the tax gain associated with leverage, they will prefer equity financing if the returns

on equity and debt satisfy equation (14.8) for those firms that will be paying corporate

taxes with certainty; that is, r(1T)r,where T(throughout this subsection) is

EcDc

the corporate tax rate for those firms that will be paying the full corporate tax rate. In

other words, firms that are indifferent between debt and equity when they are assured

of using the debt tax deduction will prefer equity financing when they are uncertain

about being able to use the tax deduction. For such firms to issue debt, (1) the after-

tax cost of debt (adjusted for its risk premium) must be less than the (risk-premium

adjusted) cost of equity when the firm can use the debt tax shield.⁹In addition, if firms

are to include equity in their capital structures, (2) the cost of debt financing must be

greater than the cost of equity financing when the firm cannot take advantage of the

interest tax deduction. Statements (1) and (2) imply:

–

rr(1 T)r(14.9)

DEcD

–

The inequality r(1 T)rimplies that a firm that has positive taxable income

EcD

(XrD) would have achieved a lower cost of capital if it had issued more debt.

D

–

However, the inequality rrimplies that a firm with negative taxable income

DE

(XrD), which cannot take advantage of the interest tax deduction, would have

D

achieved a lower cost of capital had it issued more equity.

If the inequalities in equation (14.9) are satisfied, firms will have an optimal cap-

ital structure consisting of both debt and equity. Under certainty, the optimal capital

structure includes just enough debt to eliminate the firm’s taxable earnings (XrD).

D

When firms are uncertain about their taxable earnings, their optimal debt levels can

be determined by weighing the costs associated with using higher cost debt in situ-

ations where the firm cannot use the interest tax shield against the benefit of hav-

ing a lower after-tax cost of debt, and hence lower weighted average cost of capi-

tal in situations where the firm can use the full debt tax shield.

This point is illustrated below.

Prodist and Pharmcorp

Consider two firms that initially have equal amounts of debt.

•	The first firm, Prodist, is engaged primarily in production and distribution while thesecond firm, Pharmcorp, is a pharmaceutical company with high depreciation deductions.
•	Assume that each firm currently has equal EBITDAand wishes to raise $14 million innew capital with either debt or equity. (For simplicity, rule out the possibility of a debt-equity mix.)
•	Assume that Pharmcorp’s EBITD is negative because the firm has high depreciation deductions. However, Prodist has no nondebt tax shieldsand positive taxable income.

⁹See DeAngelo and Masulis (1980) for a discussion of this point. We have presented this theory under

the assumption that all investors have the same personal tax rates and that these tax rates make them

indifferent about holding debt and equity. We recognize that some investors are not taxed and that

personal tax rates will differ between investors when there are graduated income tax rates. However, as

the appendix to this chapter indicates, firms may care most about investors who have personal tax rates

that make them indifferent about holding debt or equity. In equilibrium, the costs of debt and equity may

be set so that the most reluctant investor in the firm’s debt is one who is indifferent between debt and

equity.

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Chapter 14

How Taxes Affect Financing Choices

517

EXHIBIT14.5

Debt-Equity Trade-Offs fora Distribution Company and a Pharmaceutical Company

Prodist	Pharmcorp
(Distribution Company)	(Pharmaceutical Company)

	Debt	Equity	Debt	Equity
Item	(in $000s)	(in $000s)	(in $000s)	(in $000s)

EBITDA	$ 56,000	$ 56,000	$ 56,000	$ 56,000
Nondebt tax shields	0	0	58,000	58,000
EBIT	56,000	56,000	2,000	2,000
Interest expense	1,680	0	1,680	0
Taxable income	54,320	56,000	3,680	2,000

Corporate tax (T34%)	18,469	19,040	0	0
c
Net income	35,851	36,960	3,680	2,000

Return to new shareholders
(10% of $14,000)	0	1,400	0	1,400

Tax shields subtracted
earlier for tax purposes	58,000	58,000

Cash flows available to
original shareholders	$ 35,851	$ 35,560	$ 54,320	$ 54,600

When evaluating whether to issue debt or equity, the firms take into account the

following information:

r12%

D

r10%

E

Capital to be raised $14,000,000

T34%

c

Therefore, r(12%) r(10%) (1 T)r(7.92%).

DEcD

Exhibit 14.5 illustrates how the capital structure choices of Prodist and Pharmcorp

affect the cash flows to the original shareholders of each firm, assuming that the firms

held no previous debt. Exhibit 14.5 shows the after-tax cash flows available to the equity

holders when the two firms issue debt and when they issue equity. In this scenario, Pharm-

corp equity holders are better off if the firm issues equity because they receive

$54,600,000 instead of $54,320,000, whereas Prodist’s shareholders are better off if the

firm issues debt because they receive $35,851,000 instead of $35,560,000. The compa-

nies make different decisions because Prodist can use the tax shield benefit of debt and

Pharmcorp cannot.

Exhibit 14.5 assumes that Pharmcorp’s negative taxable earnings and Prodist’s positive

taxable earnings are certain. Of course, earnings are likely to be uncertain in the real world.

Nevertheless, since Pharmcorp has high depreciation deductions at any given debt level, the

possibility of its having negative taxable income during some period is much more likely

than it would be for Prodist. As a result, Pharmcorp’s optimal capital structure is likely to

include less debt than that of Prodist.

Given that firms with nondebt tax shields, such as large depreciation and

research and development expenditures, are more likely to have negative taxable

income at any given debt level, they should have lower debt levels than firms

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518Part IVCapital Structure

without nondebt tax shields. Nondebt tax shields are probably an important deter-

minant of the capital structures of biotech firms such as Amgen which may have

substantial value but very little taxable earnings in the near future.¹⁰However, non-

debt tax shields are probably not relevant to the capital structure choice of a firm

like AT&Twith a long history of positive taxable earnings. If AT&Twere to real-

ize negative taxable income in the present year, it could use the losses to offset past

earnings and receive an immediate refund. If the tax losses are very large, it could

defer them to offset future earnings. Thus, it would be extremely unlikely for AT&T

to lose the tax benefits associated with debt financing. Hence, from a pure tax stand-

point, AT&Tmay be better off issuing debt to fund its new investment. However,

start-up firms with large depreciation write-offs and R&D expenditures may have

negative or only slightly positive taxable incomes for a long period of time. Since

these firms may not be able to take advantage of available tax credits even if they

can be deferred for many years, they will be better off financing their investments

with equity instead of debt.

Result 14.7 summarizes the implications of the preceding discussion.

Result 14.7

Assume there is a tax gain from leverage, but the taxable earnings of firms are low rela-tive to their present values.

•	With riskless future cash flows, firms will want to use debt financing up to the pointwhere they eliminate their entire corporate tax liabilities, but they will not want to borrow beyond that point.
•	With uncertainty, firms will pick the debt ratio that weighs the benefits associatedwith the debt tax shield when it can be used against the higher cost of debt in caseswhere the debt tax shield cannot be used.
•	Firms with more nondebt tax shields are likely to use less debt financing.

The Marginal tax rateon a corporation’s profits, which is the extra tax paid per

additional dollar of profit, are often less than the statutory tax rate. Studies by Gra-

ham (1996, 2000) find that the effective marginal tax ratesof most U.S. corpora-

tions, which take into account that firms frequently employ various tax shields to defer

their tax liabilities, are often below the statutory 35 percent rate. John Graham calcu-

lated that in 1998 only about one-third of the U.S. public corporations had effective

marginal tax rates of 35 percent, and about two-fifths had effective rates of less than

5 percent. As Example 14.6 illustrated, those corporations with an effective tax rate

of 35 percent, which include most of the largest U.S. corporations, have a significant

tax gain associated with leverage. However, for the majority of the smaller corpora-

tions, the tax gain associated with leverage is likely to be quite small.