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• W2087194664 abstract "De Angelo and Masulis (1980) (hereafter, DM) presented a theory of capital structure based on a single period state preference model with a tax code incorporates a corporate tax rate and personal tax rates on bond and stock (where the former is assumes to be greater than the latter), and investment-related tax shields, such as depreciation and investment tax credits, as non-debt tax shield substitutes for or debt substitutes. The distinguishing feature of the DM model is the recognition that, in calculating taxable income, firms trade off these debt substitutes against the interest deduction resulting from the use of debt. The implication of this trade-off, given asymmetric corporate tax laws do not refund losses or allow for their sale, is the potential loss of debt substitutes in non-default states and, therefore, an interior optimal capital structure at the individual firm level. This result, while contrary to Miller's (1977) findings, provides five testable hypotheses regarding the borrowing behaviour of firms. Our interest in this paper is with their hypothesis three (H3) which states, in part, that firms with lower investment-related tax shields...will employ greater debt in their capital structure. The intuition of the model behind H3 is if the amount of depreciation deductions available decreases, holding investment constant, the probability of taxable corporate increases and, consequently, so does the probability of the firm being able to use more interest deductions. As a result, the after-tax cost of debt will decrease relative to equity, thus giving the firm an incentive to issue more debt until, at the margin, the present value of the corporate tax shelters exactly equals the present value of the personal tax costs due to the personal taxes must be paid on the interest received from holding the debt. Although intuitively appealing, this inverse relationship between the quantity of available debt substitutes and the amount of debt used by firms, which we refer to as the hypothesis, has been the subject of considerable debate and empirical study. The focal point of the debate is the DM model implicitly assumes the independence of a firm's financing and investment decisions, since the firm's investment decision and resulting debt substitutes are exogenous to their model. Endogenizing the investment decisions in a single period model includes corporate taxes and bankruptcy costs, but no personal taxes, Dotan and Ravid (1985) were able to obtain results supportive of DM. Specifically, they found an exogenous increase in debt increased the probability of an accounting loss, thereby resulting in the possibility at least part of the firm's interest deduction will be redundant. As a result, the firm's expected after-tax cost of capital increased, and its optimal investment level and corresponding debt substitutes decreased. Although they did not include personal taxes in their model, the inclusion of a fixed bankruptcy cost ensured an optimal capital structure at the individual firm level. They also argued under some circumstances the hypothesis is most prevalent for firms with the largest growth potential. On the other hand, Dammon and Senbet (1988) extended the DM model by endogenizing both the financing and investment decisions. They found the relationship between debt substitutes and the amount of debt used by a firm was ambiguous. They argued DM's substitution effect is counteracted by an income effect caused by a change in the firm's optimal investment. Employing a rationale very similar to the one described above to explain DM's H3, they confirmed an increase in the depreciation rate led to a decrease in the use of debt by a firm. This is the substitution effect, and it is negative. However, they recognized hat-an increase in the depreciation rate would not only increase the amount of debt substitutes used by the firm, but would also increase the firm's pre-tax cash flows. …" @default.
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• W2087194664 date "2009-04-08" @default.
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• W2087194664 title "The Corporate Use Of Debt Substitutes in Canada: A Test of Competing Versions Of the Substitution Hypothesis" @default.
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• W2087194664 doi "https://doi.org/10.1111/j.1936-4490.1994.tb00059.x" @default.
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