14.8The Effect of Inflation on the Tax Gain from Leverage

Recall that the last part of equation (14.5b) had an expression for the yearly savings

associated with increased leverage. Note that rD[(1 T) (1 T)(1 T)], the

DDcE

tax gain, increases as the interest rate on corporate debt increases. Although interest

rates for corporate borrowers can change for a number of reasons, the most notable

cause is a change in the expected rate of inflation. If investors expect inflation to be

high, nominal borrowing costs will also be high, reflecting the decreased purchasing

power of the dollars used to repay the loans.

Fisher’s (1930) well-known theory of interest rate changes postulates a one-to-one

relation between interest rates and expected inflation; that is, if inflation is expected to

be one percentage point higher, the nominal interest rate also increases by approxi-

mately one percentage point.¹¹This suggests that an increase in inflation increases the

tax gain associated with leverage for firms that will be able to use the interest tax deduc-

tions. Higher rates of inflation imply higher nominal borrowing costs which, in turn,

create higher tax deductions. Example 14.8 illustrates how increases in inflation can

reduce taxable income and hence reduce taxes.

Example 14.8:The Effect of Inflation on Prodist’s Corporate Taxes

Prodist (see Exhibit 14.5) has a large amount of taxable income.It raised $140 million with

12 percent notes.Show the impact of a 4 percent increase in inflation, assuming that this

increases the rate on the notes to 16 percent and that the inflation-adjusted cash flows are

unchanged.

Answer:The assumed inflation increases Prodist’s tax shield from $16.8 million to $22.4

million, as shown below:

Cash Flows (in $millions) Given

Low	High
Inflation	Inflation	Difference

Inflation-adjusted cash flows	$ 56.00	$ 56.00	—
Interest expense (Tax shields)	16.80	22.40	$5.6
Taxable income	39.20	33.60	$5.6
Corporate tax (34%)	13.33	11.42	$1.9

In this case, the increase in inflation of 4 percent leads to a $5.6 million increase

in tax shields for the same amount of debt. While this suggests that inflation encour-

ages higher leverage ratios, this is true only when a firm can take advantage of all of

its tax shields. By increasing the magnitude of the tax deduction for each dollar of debt,

inflation reduces the amount of debt needed to eliminate the firm’s taxable income.

Since firms have no tax incentive to borrow beyond this point, firms that previously

had little taxable income may reduce their leverage ratios when inflation increases.

¹¹See Chapter 9.

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522	Part IVCapital Structure

14.9	The Empirical Implications of the Analysis of Debt and Taxes

We have suggested in this chapter that taxes play an important role in determining the

debt-equity mix of U.S. corporations. Firms that are generating substantial taxable

earnings before interest and taxes (EBIT) should use a substantial amount of debt

financing to take advantage of the tax deductibility of the interest payments. However,

firms with substantial amounts of other tax shields, such as depreciation deductions

and R&D expenses, are likely to have much lower EBITrelative to their values and

would thus choose lower debt-equity ratios. Hence, in a comparison across firms, there

should be a negative correlation between a firm’s nondebt tax shields and its debt ratio.

Do Firms with More Taxable Earnings Use More Debt Financing?

In reality, we do not observe a positive cross-sectional relation between EBITand debt

ratios (see, for example, Titman and Wessels (1988)). Indeed, those firms that gener-

ate the largest amount of taxable earnings tend to have the lowest debt ratios, which is

the opposite of what we might expect from the analysis in this chapter. This negative

correlation between EBITand debt-equity ratios probably arises because firms only

rarely issue new equity, which implies the following¹²:

•	Nondebt tax shields and the use of debt financing are positively correlatedbecause firms tend to finance most major capital expenditures, which generateinvestment tax credits and depreciation deductions, with debt.
•	Firms that perform poorly (that is, have low or negative EBIT) tend toaccumulate debt to meet their expenses.

The preceding observations, however, do not rule out the possibility that firms take

taxes into account when they consider whether or not to issue equity. Indeed, a study

by MacKie-Mason (1990) found that firms do consider the tax benefits when they decide

between issuing substantial amounts of either new debt or new equity. Firms that are

unable to use their interest deductions are much more likely to issue equity than debt.

In contrast, firms that have significant taxable earnings are more likely to issue debt.

In a more recent study, which calculates the effective marginal tax rates discussed

previously, Graham (1996) found that firms with high marginal tax rates are more likely

to increase leverage than firms with low marginal tax rates.

How the Tax Reform Act of 1986 Affected Capital Structure Choice

Changes in the tax code also provide a way to judge the importance of taxes. Givoly,

Hayn, Ofer, and Sarig (1992) examined how the Tax Reform Act of 1986, which

reduced the level of nondebt tax shields for most companies, affected capital structures

in the years following the tax change.¹³They found that corporations that lost the most

nondebt tax shields under the 1986 act increased their debt levels more than firms that

were less affected by the new tax law. This evidence provides further support to the

MacKie-Mason finding that taxes play a key role in determining the optimal capital

structure of firms.

¹²There

are personal tax as well as information explanations for this behavior. See Chapters 15, 17,

and 19.

¹³In

addition to reducing both corporate and personal income taxes, the Tax Reform Act of 1986

substantially reduced or eliminated most tax shields. Most notably, the act eliminated investment tax

credits and reduced the amount that buildings and equipment could be depreciated for tax purposes.

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Markets and Corporate		Financing Choices	Companies, 2002
Strategy, Second Edition

Chapter 14

How Taxes Affect Financing Choices

523