The Capital Structure and Lifo/Fifo Choices: Tests of Cash-Flow Signaling and Tax-Shield Substitution

Posted: 26 Feb 1998

See all articles by Patricia J. Hughes

Patricia J. Hughes

Deceased

Robert Trezevant

University of Southern California - Leventhal School of Accounting

Abstract

This research empirically examines the interaction between the choices of inventory accounting method and capital structure through a parsimonious test of the predictions from the signaling model of Hughes Schwartz and Thakor (1994). We find that the debt of firms remaining at FIFO decreases after some firms switch to LIFO and that firms remaining at FIFO have higher pre-switch debt levels than firms switching to LIFO. These results are consistent with the predictions of Hughes et al. and the conclusion that among firms using the same inventory accounting method managers use debt to signal expected future cash flows. We also find that managers of firms adopting LIFO reduce debt. Although this is not consistent with the prediction of Hughes et al. it is consistent with the competing prediction of tax-shield substitution theory that managers of firms adopting LIFO decrease debt to compensate for the increased probability of tax exhaustion brought about by an increase in cost of goods sold.

JEL Classification: G32

Suggested Citation

Hughes (deceased), Patricia J. and Trezevant, Robert, The Capital Structure and Lifo/Fifo Choices: Tests of Cash-Flow Signaling and Tax-Shield Substitution. Available at SSRN: https://ssrn.com/abstract=55441

Robert Trezevant

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States
213-740-5013 (Phone)
213-747-2815 (Fax)

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