The Value of Tax Benefits

The Value of Tax Benefits∗ Philipp Immenköttery Preliminary Version, January 2014 Abstract In this paper, I show that investors discount tax benefits to a larger extent than predicted by asset pricing models. Even though the discount can partly be explained by default costs, financial stability, and information asymmetries, a large fraction of the discount is not related to common factors of capital structure models. This finding indicates that tax benefits play a less important role in the choice of target debt ratios than predicted by the trade-off theory. The results can explain the large cross- sectional dispersion of financing policies and why firms exhibit instable debt ratios. Tax avoidance and earnings management provide a higher utility for managers and shareholders which reduces the present value of future tax benefits. Keywords: tax shield; leverage; corporate financing policy; JEL classification: G31; G32; M41 ∗I am grateful for valuable comments from AndréBetzer, Diane Denis, Dieter Hess, Alexander Kempf, Peter Limbach, Oliver Pucker and participants of research seminars at the University of Pittsburgh, PA, CFR Cologne, Germany, and University of Wuppertal, Germany. yUniversity of Cologne, Corporate Finance Seminar, Albertus Magnus Platz, D 50923 Cologne, Germany, email: [email protected], tel. +49-221-4707875. 1 I Introduction Since the early work of Modigliani and Miller (1958), various attempts in the research on theoretical and empirical corporate finance have been made to explain how firms choose leverage ratios. Most commonly, tax shields serve as the primary source of benefits from financing policies. In an economy with taxes but no other frictions, an additional dollar of tax benefits increases the value of a firm by the same amount. Incorporating frictions such as default costs into an asset pricing model, Chen (2010) shows that frictions partly offset tax shields but optimal financing policies can still lever the value of a firm though tax shields by 10%. Related studies (Bhamra, Kuehn, and Strebulaev (2010)) come to similar conclusions and argue that optimizing financing policies to maximize tax benefits is a primary concern for financial managers. The empirical literature, however, offers a contrasting view. Van Binsbergen, Graham, and Yang (2010) show that only 3.5% of firm’s assets correspond to tax benefits and Graham (2000) finds that levering up could increase firm values by 15%. Hence, theoretical predictions on the value of corporate tax benefits strongly differ from the empirical findings, which forms a puzzle as to how tax benefits are priced and utilized by shareholders. This paper departs from previous work and studies this problem from a fresh perspective. I identify a discount in the marginal market value of tax benefits that cannot be explained by commonly discussed frictions in models of optimal capital structure. Share prices reflect tax benefits only partially so that the net worth of one dollar of tax benefits is substantially less than predicted by corporate valuation models. In detail, one additional dollar of tax benefits is on average rewarded only by 26.1 cents. In combination with the average level of tax benefits, the fraction of the levered firm value that corresponds to tax benefits is only 1.3%, which is significantly lower than in the previously mentioned studies. The three largest frictions that cause part of the discount of tax benefits are default costs, financial instability, and information asymmetries. In contrast to previous research, I identify the impact of each factor in a unified framework and measure its relative strength. 2 The frictions imposed by default costs are the strongest among these three forces with on average 17.4 cents per dollar of tax benefits. The second strongest friction is the instability of financing policies. Firms that commonly alter their debt ratio have a low marginal value of additional benefits. The same holds for firms that are constrained in their financing decision and cannot access external capital markets easily. The stability of financing policies is responsible for another discount of 9.3 cents per dollar. The weakest of the three forces are information asymmetries between shareholders and management that sum up to only a few cents per dollar of tax benefits. Shareholders who are not well informed about the firm reward tax benefits less in comparison to shareholders of more transparent companies. In combination, the three frictions offset tax benefits considerably, however, a substantial part remains unexplained. Depending on the empirical design, up to one third of the discount cannot be explained by these factors. Even in cases where it is most likely that none of the frictions applies, low marginal values of tax benefits are still observed. Other frictions in form of market inefficiencies such as market timing (Baker and Wurgler (2002)) and behavioral aspects (Malmendier, Tate, and Yan (2011)) that have a significant influence on firms’ financing decisions do not influence the marginal value of tax benefits, neither in economic nor in statistical terms. This study contributes to the literature on corporate capital structure in the following ways. First, the results of the study shed light on the controversy of the importance of target debt ratios that are determined through the tax deductibility of interest payments. While Leary and Roberts (2005) highlight the importance of the target adjustment process, Welch (2004) shows that firms do only little to offset deviations from target debt ratios. DeAngelo and Roll (2012) document a large variation of corporate debt ratios that seems to be inconsistent with target adjustment behavior. For firms with low marginal values of tax benefits, a dispersion and instability of debt ratios becomes plausible as the firm cannot increase its value sufficiently when adhering to a target leverage policy. Only for firms where shareholders attribute a high marginal value to tax benefits, management should follow a 3 strict target that exhausts tax shields. In line with Fama and French (2012), shareholders' low marginal utility of tax benefits shows that target leverage ratios are rather of second order importance in financing decisions. Second, I emphasize shareholders' utility in the valuation of corporate tax benefits. The unexplained discount of the value of tax benefits is due to shareholders' low utility of cash flows through tax benefits which is founded on different economic reasons. Tax avoidance and tax sheltering policies play an important role in the managerial decision making process which cannot be separated from financing decisions (Shackelford and Shevlin (2001)). This effect is further amplified by incentive based compensation of corporate executives that lead managers to focus on tax avoidance (Desai and Dharmapala (2006)). This interaction of tax management and financing decisions leads to a low utility of tax benefits because tax sheltering provides more potential for generating shareholder value than tax shields from interest payments. These results indicate that managerial strategies might not focus on exhausting the full potential for tax benefits so that maximizing tax benefits is not a primary concern when choosing target capital structures. The results presented in this paper do not contradict the trade-off theory of capital structure. My results document the existence of the trade-off between tax benefits and costs of debt financing, however, they show that this trade-off is not able to fully explain corporate financing behavior. Despite low marginal values and low utilities, firms can adhere to dynamic target debt ratios that provide tax benefits, however, their speed of adjusting to the target debt ratios is expected to be rather slow. Simulations by DeAngelo and Roll (2012) show that a high variation in the time series of debt ratios can be consistent with time varying targets and slow speeds of adjustments. The cross-sectional differences in shareholders' utility of tax benefits make it challenging to identify the targets as well as the target adjustment behavior. My study is structured as follows. In section II, I develop a parsimonious model to establish hypotheses on how a change in tax benefits translates into a change in shareholders' 4 wealth and how frictions materialize into a discount of the marginal value of tax benefits. In a Modigliani and Miller (1958) framework, shareholders utilize tax benefits completely, i.e. each additional dollar of tax benefits is fully reflected in shareholders' wealth. The stepwise inclusion of new variables such as default costs and information asymmetries identifies the frictions that reduce the marginal value of tax benefits. The resulting econometric model is closely related to value relevance regressions on possibly inefficient markets (Aboody, Hughes, and Liu (2002)) and the estimation of the marginal value of cash holdings by Faulkender and Wang (2006). In section III, I discuss the sample selection of US firms and the choice of variables that are fed into the model. Following Graham (2000), I account for both corporate and personal taxes so that tax benefits equal the benefit of directing one dollar to investors as interest instead of equity gains. Section IV presents the empirical results on the marginal value of tax benefits, the identification of frictions, and its cross-sectional variation. Finally, section V discusses shareholders' utility of tax benefits and section VI concludes. II Linking tax benefits and shareholders' wealth This section presents a framework for linking tax benefits, shareholder's wealth, and excess returns. The identification strategy of the empirical part is based on this framework as it shows how the marginal value of tax benefits can be singled out. The model is hold in a parsimonious but general manner to provide empirical applicability. II.1 A model for shareholder's value of tax benefits Consider a representative firm in an economy where interest payments on corporate debt are deductible from corporate taxable income. Besides the existence of a corporate income tax, individuals have to pay taxes upon their personal income from interests, dividends, and capital gains.

Load more