Do Taxes Affect Corporate Financing Decisions? Jeffrey K. MacKie -Mason

1. Do Taxes Affect Corporate Financing Decisions?Jeffrey K. MacKie-Mason Article Overview Presentation: Clark Hildabrand

2. Corporate Taxation Basics • General equation for corporate tax system: Taxes = ([Revenues – Expenses] x τ) – Investment Tax Credit • Expenses can include cash-flow costs of doing business, interest payments, depreciation, and tax loss carryforwards (TLCFs) • Investment Tax Credit (ITC) for 6-10% of investment expenditures discontinued in 1986 • Tax exhaustion occurs when a firm has no positive taxable income or cannot claim all of its deductions

3. Corporate Tax and Investment Theory • Tax Hypothesis advocated by MacKie-Mason • Tax shields such as TLCFs and ITCs decrease attractiveness of financing investment through debt with its interest deductions • Firms with TLCFs have high probability of facing zero tax rates again: TLCFs substantially lower expected marginal τ • Firms with high ITC generally profitable: ITC has little impact on expected marginal τ • Firms with ITC and nearly tax-exhausted less likely to issue debt

4. Corporate Tax and Investment Theory (cont.) • Disadvantages of Debt • Interest commitment might increase likelihood of financial distress • Moral hazard due to conflicts of interest between managers and lenders can lead to investment inefficiencies • Advantages of Equity • Dividend payments of equity signal to investors that the company is doing well financially • Assumes a nested decision-making model with debt and equity as the two public issue options to raise funds for investments

5. Literature Myers (1984) and Poterba (1986) found little empirical support for idea that taxes significantly affect financing decisions DeAngelo and Masulis (1980) showed that a firm’s effective marginal tax rate on interest deductions depends on the firm’s non-debt tax shields Bradley, Jarrell, and Kim (1984), Titman and Wessels (1988), and other papers espousing the moral hazard hypothesis predict ITC encourages use of debt since ITC high when a firm’s value depends substantially on tangible assets-in-place which lowers moral hazard costs

6. Basic Econometric Model • Value of incremental debt is a function of potential tax shields (T), T interacting with likelihood of tax exhaustion (T x X), and other factors (Z): ΔVB = f(T, T x X, Z) Tax Hypothesis predicts T & T xXnegatively related to ΔVB • Other factors include financial distress costs, investment inefficiencies, signaling costs, debt/asset ratio targets, industry dummies, and year dummies

7. Data • SEC Registered Offerings Statistics tape records the registration of every security for public offering • Selected a sample of 1747 registrations from 1977 to 1987 • Included only primary, seasoned offerings by firms covered by the COMPUSTAT tapes • Data on firm characteristics from COMPUSTAT • Explanatory variables measured during year prior to the security issue to avoid simultaneity bias • Private debt and equity not considered in this article • Uses Altman’s (1968) ZPROB to measure financial condition • Lower ZPROB score means less financially secure and more likely to face zero tax rates

8. Likelihood Function • The firm’s choice between debt and equity is observed but not the realization of the incremental value of the choice (ΔVi): ΔVi = x’βi+ εi , ~ N(0, Σ) • When y = 1, then the firm finances with debt, and when y = 0, the firm finances with equity • Estimates the βi given the observations of debt or equity issues and the characteristics vector (yn, xn) pr(y = 1 | x) = pr(ΔVB > ΔVE) pr(y = 1 | x) = pr(ε2 – ε1 < x’ β) • Obtains estimates of by maximizing the log of the likelihood function for the sample

9. Results • As predicted, TLCFs reduce frequency of debt issues since deductibility of interest payments unlikely to sway firms already expecting tax exhaustion • ITC strongly increases likelihood of debt issues since firms with high amounts of ITC unlikely to reach tax exhaustion • However, ITC x ZPROB shows that firms nearing tax exhaustion attempt to increase their tax shields and finance through equity

10. Conclusion • Results confirm the tax hypothesis since the desirability of debt finance at the margin varies positively with the effective marginal tax rate • Positive coefficient for ITC does not contradict tax hypothesis since moral hazard costs outweigh the modest negative coefficient predicted by the tax hypothesis • Summary statistics show strength of the findings with the model correctly classifying the observed choices in the sample 77% of the time • Taxes do affect corporate financing decisions