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How Big is the Tax Advantage to Debt?
Author(s) -
KANE ALEX,
MARCUS ALAN J.,
McDONALD ROBERT L.
Publication year - 1984
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.1984.tb03678.x
Subject(s) - debt , economics , capital structure , leverage (statistics) , monetary economics , valuation (finance) , tax shield , bankruptcy , debt ratio , cost of capital , microeconomics , state income tax , incentive , finance , gross income , tax reform , public economics , mathematics , statistics
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 jump 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.