How Big is the Tax Advantage to Debt?

24 Pages Posted: 26 May 2004 Last revised: 9 Jul 2010

See all articles by Alex Kane

Alex Kane

University of California, San Diego (UCSD) - Graduate School of International Relations and Pacific Studies (IRPS)

Alan J. Marcus

Boston College - Department of Finance

Robert L. McDonald

Northwestern University - Kellogg School of Management

Date Written: March 1984

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 junip 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.

Suggested Citation

Kane, Alex and Marcus, Alan J. and McDonald, Robert L., How Big is the Tax Advantage to Debt? (March 1984). NBER Working Paper No. w1286. Available at SSRN: https://ssrn.com/abstract=321331

Alex Kane (Contact Author)

University of California, San Diego (UCSD) - Graduate School of International Relations and Pacific Studies (IRPS) ( email )

9500 Gilman Drive
La Jolla, CA 92093-0519
United States

Alan J. Marcus

Boston College - Department of Finance ( email )

Fulton Hall
Chestnut Hill, MA 02467
United States
617-552-2767 (Phone)
617-552-0431 (Fax)

Robert L. McDonald

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8344 (Phone)
847-491-5719 (Fax)

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