Tax Rates and Corporate Capital Structure

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TAX RATES AND CORPORATE CAPITAL STRUCTURE The magnitude of the effective tax advantage of debt has important implications for corporate financial behavior. One issue, which has been examined extensively in corporate finance literature, is whether the value of a company is affected by the company’s leverage ratio. DeAngelo and Masulis1 have shown that financing decisions can affect the value of the firm if the effective tax advantage to debt finance varies or is reduced by the presence of non-debt tax shields such as investment allowance and depreciation deductions. In Indian companies, the effective tax rate is an important determinant for the amount of debt they can avail. Hence there has to be a definite relationship between debt and effective tax rate for the companies. One of the hypotheses of DeAngelo and Masulis postulates this relationship. The hypothesis states that, “ceteris paribus … firms subject to lower corporate tax rate will employ less debt in their capital structure …” The fact that the statutory tax rate does not change frequently may be a possible explanation for this relationship. However, the presence of non-debt tax shields may decrease the taxable income to zero. Hence, the relevant corporate tax rate has to be the effective tax rate and not the statutory tax rate. DeAngelo and Masulis cite the findings of Corcoran2 and Holland and Myers3 based on the time series of effective tax rates, that firms use more debt during inflationary periods. This is because inflation increases the corporate tax rate due to the decrease in the real value of deductions that are based on historical book value. Similarly, Fame4 and Gonedes5 also give indirect evidence on the tax effects of inflation on historical costs. Based on the theoretical hypothesis of DeAngelo and Masulis, the following hypothesis is framed to test the relationship between corporate

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