Leverage Dynamics, the Endogeneity of Corporate Tax Status and Financial Distress Costs, and Capital Structure
23 Pages Posted: 6 Mar 2008
Date Written: March 4, 2008
This paper empirically examines capital structure decisions in the presence of leverage dynamics and when corporate tax status and financial distress costs are allowed to be endogenous. We deal with the endogeneity of corporate tax by using a before-financing measure of the marginal corporate tax rate as a proxy for the effective corporate tax rate. We find strong evidence of a positive relation between leverage and taxes, irrespective of whether leverage dynamics are allowed for. Using the estimated probability of financial distress as a proxy for financial distress costs, we find that the role of leverage dynamics is crucial to the effect of financial distress on leverage. We find that when leverage dynamics are excluded, the estimated probability of financial distress is positively associated with leverage, that is, an increasing probability of financial distress leads to an increase in leverage. This seems counter-intuitive. When leverage dynamics are included in the model, the probability of financial distress is negatively related to leverage. Our results show that capital structure dynamics are important and that firms trade-off the tax benefit that arises from increasing debt with the increase in possible financial distress that arises from increasing debt.
Keywords: Capital structure, Dynamic Tradeoff theory, Endogeneity, Corporate tax status, Financial distress
JEL Classification: G32
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