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How Big is the Tax Advantage to Debt?

Alex Kane, Alan J. Marcus and Robert L. McDonald
The Journal of Finance
Vol. 39, No. 3, Papers and Proceedings, Forty-Second Annual Meeting, American Finance Association, San Francisco, CA, December 28-30, 1983 (Jul., 1984), pp. 841-853
Published by: Wiley for the American Finance Association
DOI: 10.2307/2327948
Stable URL: http://www.jstor.org/stable/2327948
Page Count: 13
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How Big is the Tax Advantage to Debt?
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Abstract

This paper uses an option valuation model of the firm to answer the question, "What magnitude tax advantage to debt is consistent with the range of observed corporate debt ratios?" We incorporate into the model differential personal tax rates on capital gains and ordinary income. We conclude that variations in the magnitude of bankruptcy costs across firms can not by itself account for the simultaneous existence of levered and unlevered firms. When it is possible for the value of the underlying assets to jump discretely to zero, differences across firms in the probability of this jump can account for the simultaneous existence of levered and unlevered firms. Moreover, if the tax advantage to debt is small, the annual rate of return advantage offered by optimal leverage may be so small as to make the firm indifferent about debt policy over a wide range of debt-to-firm value ratios.

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