Taxes and the Tradeoff Theory
Fahid Fayaz Darangay
The tradeoff theory justifies moderate debt ratios. It says that the firm will borrow up to the point where the marginal value of tax shields on additional debt is just offset by the increase in the present value of possible costs of financial distress. Financial distress refers to the costs of bankruptcy or reorganization, and also to the agency costs that arise when the firm’s creditworthiness is in doubt. I discuss some of these costs further below. For now, just assume that costs of financial distress exist, and that the prospect of financial distress can drag down the current market value of the firm.
The tradeoff theory is in immediate trouble on the tax front, because it seems to rule out conservative debt ratios by taxpaying firms. If the theory is right, a value-maximizing firm should never pass up interest tax shields when the probability of financial distress is remotely low. Yet there are many established, profitable companies with superior credit ratings operating for years at low debt ratios, including Microsoft and the major pharmaceutical companies.
These examples are not unusual. About half the firms in Graham’s (2000) sample were paying taxes at the full statutory rate; the average firm in this subsample could have doubled its interest payments in confident expectation of doubled interest tax shields. Graham (pp. 1916, 1934) estimates that these companies could have added 7.5 percent on average to firm value by “levering up” to still-conservative debt ratios. This is not small change. A 7.5 percent deviation from Modigliani and Miller’s (1958) leverage-irrelevance proposition should prompt a vigorous supply response from security issuers. One cannot accept Modigliani and Miller and at the same time ignore many mature corporations’ evident lack of interest in the tax advantages of debt.
Studies of the determinants of actual debt ratios consistently find that the most profitable companies in a given industry tend to borrow the least. For example, Wald (1999) found that profitability was “the single largest determinant of debt/ asset ratios” in cross-sectional tests for the United States, United Kingdom, Germany, France and Japan.
High profits mean low debt, and vice versa. But if managers can exploit valuable interest tax shields, as the tradeoff theory predicts, we should observe exactly the opposite relationship. High profitability means that the firm has more taxable income to shield, and that the firm can service more debt without risking financial distress.
The tradeoff theory cannot account for the correlation between high profitability and low debt ratios. It does no good to say (without further explanation) that managers are “excessively conservative” or “not value-maximizing.” That amounts to blaming managers, rather than economists, for the failure of the economists’ theory. Also, an examination of financing tactics quickly dismisses the idea that managers don’t pay attention to taxes.
Floating-rate preferred shares are creatures of the tax code, and a clear illustration of the importance of taxes in financing tactics. These preferreds’ dividend payments are tied to short-term interest rates. This stabilizes the preferreds’ prices. They are purchased by other corporations with excess cash available for short-term investment. The key tax advantage is that only 30 percent of inter-corporate dividends are taxed. The effective corporate tax rate for preferred dividends is therefore .3 3 .35 5.105 or 10.5 percent. The financial innovators who first created floating-rate preferred shares thus created a partially tax-exempt security that acted like a safe, short-term, money-market instrument.
Financial leases are also largely tax-driven. When the lessor’s tax rate is higher than the lessee’s, there is a net gain because the lessor’s interest and depreciation tax shields are front-loaded—that is, mostly realized earlier—than the taxes paid on the lease payments. The tax advantage is due to the time value of money, and therefore increases in periods of high inflation and high nominal interest rates (Myers, Dill and Bautista, 1977).
There are many further examples of tax-driven financing tactics. Finding clear evidence that taxes have a systematic effect on financing strategy, as reflected in actual or target debt ratios, is much more difficult. In Myers (1984, p. 588), after a review of the then-available empirical work, I concluded that there was “no study clearly demonstrating that a firm’s tax status has a predictable, material effect on its debt policy. I think that the wait for such a study will be protracted.”
A few such studies have since appeared, although some relate in part to financing tactics, and none gives conclusive support for the tradeoff theory. For example, MacKie-Mason (1990) estimated a probit model for companies issuing debt or equity securities. He predicted that companies with low marginal tax rates—for example companies with tax loss carry-forwards—would be more likely to issue equity, compared to more profitable companies facing the full statutory tax rate. This was clearly true in his sample.
MacKie-Mason’s (1990) result is consistent with the tradeoff theory, because it shows that taxpaying firms favor debt. But it is also consistent with a Miller (1977) equilibrium in which the value of corporate interest tax shields is entirely offset by the low effective tax rate on capital gains. In this case, a firm facing a low enough tax rate would also use equity, because investors pay more taxes on debt interest than on equity income. Thus, we cannot conclude from MacKie-Mason’s results that interest tax shields make a significant contribution to the market value of the firm or that debt ratios are determined by the tradeoff theory.
Graham (1996) also finds evidence that changes in long-term debt are positively and significantly related to the firm’s effective marginal tax rate. Again this shows that taxes affect financing decisions, at least at the tactical level. It does not show that the present value of interest tax shields is materially positive. Fama and French (1998), despite an extensive statistical search, could find no evidence that interest tax shields contributed to the market value of the firm.
The tradeoff theory of optimal capital structure has strong commonsense appeal. It rationalizes moderate debt ratios. It is consistent with certain obvious facts, for example, that companies with relatively safe, tangible assets tend to borrow more than companies with risky, intangible assets. (High business risk increases the odds of financial distress, and intangible assets are more likely to sustain damage if financial distress is encountered.) However, the words “consistent with” are particularly dangerous in this branch of empirical financial economics. A fact or statistical finding is often consistent with two or more competing capital structure theories. It is too easy to interpret results as supporting the theory that one is used to.
Concluded from Stewart C. Myers’ paper.
(The author is currently pursuing Masters in Financial Economics from Madras School of Economics, Chennai)