Non Debt Tax Shields

Published Date: 02 Nov 2017

Capital structure:

This paper surveys capital structure theories based on agency costs, asymmetric information, product/input market interactions, and corporate control considerations (but excluding tax-based theories). For each type of model, a brief overview of the papers surveyed and their relation to each other is provided. The central papers are described in some detail, and their results are summarized and followed by a discussion of related extensions. Each section concludes with a summary of the main implications of the models surveyed in the section. Finally, these results are collected and compared to the available evidence. Suggestions for future research are provided.

The modern theory of capital structure began with the celebrated paper of Modigliani and Miller (1958). They (MM) pointed the direction that such theories must take by showing under what conditions capital structure is irrelevant. Since then, many economists have followed the path they mapped. Now, some 30 years later it seems appropriate to take stock of where this research stands and where it is going. Our goal in this survey is to synthesize the recent literature, summarize its results, relate these to the known empirical evidence, and suggest promising avenues for future research.1

Firm size :

Several studies hypothesize a relation between board size and financial performance. Empirical tests of the relation exist in only a few studies of large U.S. firms. We find a significant negative correlation between board size and profitability in a sample of small and midsize Finnish firms. Finding a board-size effect for a new and different class of firms affects the range of explanations for the board-size effect.

Asset tangibility the firm:

This paper examines the relative importance of many factors in the capital structure decisions of publicly traded American firms from 1950 to 2003. The most reliable factors for explaining market leverage are: median industry leverage (+ effect on leverage), market-to-book assets ratio (−), tangibility (+), profits (−), log of assets (+), and expected inflation (+). In addition, we find that dividend-paying firms tend to have lower leverage. When considering book leverage, somewhat similar effects are found. However, for book leverage, the impact of firm size, the market-to-book ratio, and the effect of inflation are not reliable. The empirical evidence seems reasonably consistent with some versions of the trade-off theory of capital structure.

Market to book ratio :

It is well known that firms are more likely to issue equity when their market values are high, relative to book and past market values, and to repurchase equity when their market values are low. We document that the resulting effects on capital structure are very persistent. As a consequence, current capital structure is strongly related to historical market values. The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market.

Non-debt tax shield:

a model of corporate leverage choice is formulated in which corporate and differential personal taxes exist and supply side adjustments by firms enter into the determination of equilibrium relative prices of debt and equity. The presence of corporate tax shield substitutes for debt such as accounting depreciation, depletion allowances, and investment tax credits is shown to imply a market equilibrium in which each firm has a unique interior optimum leverage decision (with or without leverage-related costs). The optimal leverage model yields a number of interesting predictions regarding cross-sectional and time-series properties of firms' capital structures. Extant evidence bearing on these predictions is examined.

The purpose of this article is to determine market orientation's relative impact on small-business performance, compared to other influences, in an integrated model using longitudinal data. Contrary to expectations based on the management literature, the results indicate weak causal relationships between market environment, small-firm structure, and small-firm strategy. The results further indicate weak influences of these variables, but strong and consistent influences of market orientation, on various measures of small-firm performance. Contrary to expectations based on business policy literature, relative product quality and new product success were not significant influences on profitability, perhaps due to the significant influence of market orientation on these variables. In addition, although increases in growth/share had a significant short-term influence on increases in profitability high levels of previous years'firm growth/share had a negative influence on current profitability. The previous year's level of firm coordinating systems and market competitive intensity has a significant impact on the level of small-firm market orientation.

 Non-Debt Tax Shields

DeAngelo and Masulis [12] present a model of optimal capital structure that incorporates the impact of corporate taxes, personal taxes, and non-debt-related corporate tax shields. They argue that tax deductions for depreciation and investment tax credits are substitutes for the tax benefits of debt financing. As a result, firms with large non-debt tax shields relative to their expected cash flow include less debt in their capital structures.

Indicators of non-debt tax shields include the ratios of investment tax credits over total assets (ITC/TA), depreciation over total assets (D/TA), and a direct estimate of non-debt tax shields over total assets (NDT/TA). The latter measure is calculated from observed federal income tax payments (T), operating income (OI), interest payments (i), and the corporate tax rate during our sample period (48%), using the following equation:

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which follows from the equality

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These indicators measure the current tax deductions associated with capital equipment and, hence, only partially capture the non-debt tax shield variable suggested by DeAngelo and Masulis. First, this attribute excludes tax deductions that are not associated with capital equipment, such as research and development and selling expenses. (These variables, used as indicators of another attribute, are discussed later.) More important, our non-debt tax shield attribute represents tax deductions rather than tax deductions net of true economic depreciation and expenses, which is the economic attribute suggested by theory. Unfortunately, this preferable attribute would be very difficult to measure.

Growth

As we mentioned previously, equity-controlled firms have a tendency to invest sub optimally to expropriate wealth from the firm's bondholders. The cost associated with this agency relationship is likely to be higher for firms in growing industries, which have more flexibility in their choice of future investments. Expected future growth should thus be negatively related to long-term debt levels. Myers, however, noted that this agency problem is mitigated if the firm issues short-term rather than long-term debt. This suggests that short-term debt ratios might actually be positively related to growth rates if growing firms substitute short-term financing for long-term financing. Jensen and Meckling [20], Smith and Warner [36], and Green [17] argued that the agency costs will be reduced if firms issue convertible debt. This suggests that convertible debt ratios may be positively related to growth opportunities.

It should also be noted that growth opportunities are capital assets that add value to a firm but cannot be collateralized and do not generate current taxable income. For this reason, the arguments put forth in the previous subsections also suggest a negative relation between debt and growth opportunities.

Indicators of growth include capital expenditures over total assets (CE/TA) and the growth of total assets measured by the percentage change in total assets (GTA). Since firms generally engage in research and development to generate future investments, research and development over sales (RD/S) also serves as an indicator of the growth attribute

Size

A number of authors have suggested that leverage ratios may be related to firm size. Warner [41] and Ang, Chua, and McConnell [1] provide evidence that suggests that direct bankruptcy costs appear to constitute a larger proportion of a firm's value as that value decreases. It is also the case that relatively large firms tend to be more diversified and less prone to bankruptcy. These arguments suggest that large firms should be more highly leveraged.

The cost of issuing debt and equity securities is also related to firm size. In particular, small firms pay much more than large firms to issue new equity (see Smith [34]) and also somewhat more to issue long-term debt. This suggests that small firms may be more leveraged than large firms and may prefer to borrow short term (through bank loans) rather than issue long-term debt because of the lower fixed costs associated with this alternative.

Profitability

Myers [27] cites evidence from Donaldson [13] and Brealey and Myers [7] that suggests that firms prefer raising capital, first from retained earnings, second from debt, and third from issuing new equity. He suggests that this behavior may be due to the costs of issuing new equity. These can be the costs discussed in Myers and Majluf [28] that arise because of asymmetric information, or they can be transaction costs. In either case, the past profitability of a firm, and hence the amount of earnings available to be retained, should be an important determinant of its current capital structure. We use the ratios of operating income over sales (OI/S) and operating income over total assets (OI/TA) as indicators of profitability

Measures of Capital Structure:

Six measures of financial leverage are used in this study. They are long-term, short-term, and convertible debt divided by market and by book values of equity.8 Although these variables could have been combined to extract a common "debt ratio" attribute, which could in turn be regressed against the independent attributes, there is good reason for not doing this. Some of the theories of capital structure have different implications for the different types of debt, and, for the reasons discussed below, the predicted coefficients in the structural model may differ according to whether debt ratios are measured in terms of book or market values. Moreover, measurement errors in the dependent variables are subsumed in the disturbance term and do not bias the regression coefficients.

Data limitations force us to measure debt in terms of book values rather than market values. It would, perhaps, have been better if market value data were available for debt. However, Bowman [5] demonstrated that the cross-sectional correlation between the book value and market value of debt is very large, so the misspecification due to using book value measures is probably fairly small. Furthermore, we have no reason to suspect that the cross-sectional differences between market values and book values of debt should be correlated with any of the determinants of capital structure suggested by theory, so no obvious bias will result because of this misspecification.

There are, however, some other important sources of spurious correlation. The dependent variables used in this study can potentially be correlated with the explanatory variables even if debt levels are set randomly. Consider first the case where managers set their debt levels according to some randomly selected target ratio measured at book value.9 This would not be irrational if capital structure were in fact irrelevant. If managers set debt levels in terms of book value rather than market value ratios, then differences in market values across firms that arise for reasons other than differences in their book values (such as different growth opportunities) will not necessarily affect the total amount of debt they issue. Since these differences do, of course, affect the market value of their equity, this will have the effect of causing firms with higher market/book value ratios to have lower debt/market value ratios. Since firms with growth opportunities and relatively low amounts of collateralizable assets tend to have relatively high market value/book value ratios, a spurious relation might exist between debt/market value and these variables, creating statistically significant coefficient estimates even if the book value debt ratios are selected randomly.10

Similar spurious relations will be induced between debt ratios measured at book value and the explanatory variables if firms select debt levels in accordance with market value target ratios. If some firms use book value targets while others use market value targets, both dependent variables will be spuriously correlated with the independent variables. Fortunately, the book and market value debt ratios induce spurious correlation in opposite directions. Using dependent variables scaled by both book values and market values may then make it possible to separate the effects of capital structure suggested by theory, which predicts coefficient estimates of the same sign for both dependent variable groups, from these spurious effects.