Download Optimal Capital Structure with Taxes: Firm's Preference for Debt and Tax Benefits and more Study notes Economics in PDF only on Docsity! Optimal Capital Structure with Taxes Do Firms Prefer Debt? When firms raise new capital from investors, they do so primarily by issuing debt. In fact, in most years, aggregate equity issues are negative, meaning that firms are reducing the amount of equity outstanding by buying shares. The data in figure 15.5 show a clear preference for debt as a source of external financing for the total population of U.S. firms. As Figure 15.5 also shows, capital expenditures greatly exceed firms’ external financing, implying that most investment and growth is supported by internally generated funds, such as retained earnings. Thus, even though firms have not issued new equity, the market value of equity has risen over time as firms have grown. The aggregate data in Figure 15.6 masks two important tendencies. First, the use of leverage varies greatly by industry. Second, many firms retain large cash balances to reduce their effective leverage. These patterns are revealed in Figure 15.7, which shows net debt as a fraction of firm enterprise value for a number of industries and the overall market. Firms in growth industries like biotechnology or high technology carry very little debt and maintain large cash reserves, whereas airlines, real estate firms, trucking and automotive firms, and utilities have high leverage ratios. Limits to the Tax Benefit of Debt To receive the full tax benefits of leverage, a firm need not use 100% debt financing. A firm receives a tax benefit only if it is paying taxes in the first place. That is, the firm must have taxable earnings. This constraint may limit the amount of debt needed as a tax shield. Now consider a case, in which the firm has excess leverage so that interest payments exceed EBIT. In this case, the firm has a net operating loss, but there is no increase in the tax savings. Because the firm is paying no taxes already, there is no immediate tax shield from the excess leverage. Thus, no corporate tax benefit arises from incurring interest payments that regularly exceed EBIT. Therefore, the optimal level of leverage from a tax saving perspective is the level such that interest equals EBIT. Of course, it is unlikely that a firm can predict its future EBIT precisely. If there is uncertainty regarding EBIT, then with a higher interest expense there is a greater risk that interest will exceed EBIT. As a result, the tax savings for high levels of interest falls, possibly reducing the optimal level of the inte rest pay ment , as sho wn in Figur e 15.8. In gene ral, as a fir m’s inte rest
