The Tax Disadvantage of Debt and the Value of Leverage

Abstract

This study identifies a tax disadvantage of debt that arises when a firm’s business model fails and it liquidates its assets at a loss. If the outstanding debt is greater than or equal to the salvage value of the firm’s assets, the firm will not have assets to generate income to use the loss generated by the liquidation. Anticipating this situation, the firm issues debt that is less than the salvage value of its assets, even if the probability of liquidation in the short run is very low. If the probability of liquidation in the short run is not too low, an all-equity capital structure is optimal despite the tax advantage of debt. For a given level of debt, the value of leverage in this model can be substantially less than when the firm is assumed to exist in perpetuity.

Keywords

capital structure underleverage corporate tax G32 G33 H25

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