Taxes and Financing Decisions
33 Pages Posted: 12 Jan 2005
Date Written: October 2004
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: Suggested Citation