Next week in class we begin capital structure, so I simply could not pass up this article by Lewellen and Lewellen on capital structure and taxes.
Short Version: The authors show that internal equity has tax advantages. Moreover, "The trade-off between debt, retained earnings, and external equity depends critically on the tax basis of investors' shares relative to current price." Their paper suggest that much of what we thought we knew about capital structure, may not be quite right! "These predictions would all be contrary to the way trade-off theory is often interpreted"
Longer Version: The paper develops the consequences of Miller's 1977 paper that showed the tax benefits of debt are overstated when personal taxes are ignored. In their current paper, Lewellen and Lewellen (LL) build on this insight.
LL summarize the reson for their paper in a nice succient parapgraph:
"Our results follow from a simple observation whose importance for capital structure seems largelyunappreciated: when a firm distributes cash to shareholders, using either dividends or repurchases, thepayout triggers personal taxes that could otherwise be delayed. Thus, using internal cash for investment, rather than paying it out to equityholders, has a tax advantage – the deferral of personal taxes – thatpartially offsets the double-taxation costs of equity. An immediate implication is that internal equity is less costly than external equity for tax reasons."
Of course this is not new. Other have looked at this and have shown that external equity has some tax disadvantages, what is different in this paper is that looks not only at differing capital gains rates, but also is based in part on what the tax basis of the shares are to investors.
"Most clearly, our results show that the traditional view of debt and taxes, as exemplified by Miller (1977), is valid only when capital gains are taxed on accrual.... The main features of the
traditional view are (i) internal and external equity are assumed to be equivalent, and (ii) the tax cost of equity depends on the total taxation of equity relative to debt, (1 – τc)(1 – τe) – (1 – τi). The first statement is generally false and the second is, at best, incomplete (it misses the distinction between internal and external equity and it is unclear about τe)."
A consequence of this is that the tax advantages often get swept under the rug and we look elsewhere for explanations. As teh authors state:
"Thus, capital structure dynamics in these models are driven by agency problems and adjustment costs – the focus of the studies –not by a tax advantage of internal over external equity. The literature sometimes acknowledges that, because capital gains are not taxed until they are realized, the effective tax rate on capital gains is less than the statutory rate. But simply allowing for a low effective tax rate isn’t sufficient because it misses
the differential tax costs of internal and external equity."
So what does this all mean? Firms may have less of a reason to increase debt and a firm's capital structure is a function of not only firm characteristics, but also investor characteristics (such as effective tax rate).
And then the kicker! The model helps to explain the currrent problems we see with the trade-off theories:
"Indeed, our model suggests a kind of tax-induced pecking order, with debt and internal equity both preferred to external equity (the ordering of debt and internal equity is ambiguous and could change over time, for example, as a function of current leverage). Thus, our model might help explain two findings that have been described as ‘major failures’ of trade-off theory: (i) profitable firms seem to have too little leverage, and (ii) changes in debt largely absorb short-run variation in internal cash surpluses and deficits (e.g.,Shyam-Sunder and Myers, 1999; Fama and French, 2002)." (pp. 17-18)
Wow. I^3 (Informative, Important, and Interesting!)
Lewellen, Jonathan W. and Lewellen, Katharina, "Taxes and Financing Decisions" (October 2004). AFA 2005 Philadelphia Meetings Paper. http://ssrn.com/abstract=647847