Taxes and Financing Decisions

33 Pages Posted: 12 Jan 2005

See all articles by Jonathan Lewellen

Jonathan Lewellen

Dartmouth College - Tuck School of Business; National Bureau of Economic Research (NBER)

Katharina Lewellen

Dartmouth College - Tuck School of Business

Date Written: October 2004

Abstract

This paper studies the tax effects of financing decisions. We show that subtle, often unstated, tax assumptions play a key role in many capital structure theories, including in the models of Miller (1977), Auerbach (1979), and Hennessy and Whited (2004). Our central thesis is that, under quite general conditions, the tax costs of internal equity are less than the tax costs of external equity. It follows that optimal leverage is a function of internally generated cashflows, that debt ratios can wander around without a specific target, and that a firm's cost of capital depends on its mix of internal and external finance, not just its mix of debt and equity. The trade-off between debt, retained earnings, and external equity depends critically on the tax basis of investors' shares relative to current price. We estimate how the tax basis varies cross-sectionally and through time for a large sample of U.S. firms.

JEL Classification: G32, H24, H25

Suggested Citation

Lewellen, Jonathan W. and Lewellen, Katharina, Taxes and Financing Decisions (October 2004). Available at SSRN: https://ssrn.com/abstract=647847 or http://dx.doi.org/10.2139/ssrn.647847

Jonathan W. Lewellen (Contact Author)

Dartmouth College - Tuck School of Business ( email )

Hanover, NH 03755
United States
603-646-8650 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Katharina Lewellen

Dartmouth College - Tuck School of Business ( email )

Hanover, NH 03755
United States

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