Corporate Financial Policy, Taxation, and Macroeconomic Risk, Issue 3902
This paper develops a simple model of corporate financial structure intended to formalize the macroeconomic concern over excessive leverage. In particular, we attempt to rationalize why firms designing an optimal capital structure would choose a level of debt that leaves them heavily exposed to macroeconomic risk. Our starting point is a variant of the "corporate control" model often used to motivate debt as the optimal financial contract. We modify this framework in two ways. First, we include common risks, interpretable as business cycle risks, as well as idiosyncratic risks. Second, we include corporate and investor-level taxes, and consider the implications of a net tax bias against equity finance. The tax distortion confronts firms with a tradeoff ex ante between the costs of equity finance and the costs of increased exposure to macroeconomic risk accompanying debt finance. In this regard, an equilibrium with "excessive leverage" is possible. Further, despite the possibility of renegotiation, debt is in general less effective than equity in insulating the firm against aggregate risk. Our model leads to the prediction that individual firm dividends may vary with macroeconomic conditions, even after controlling for the effects of relevant firm-specific performance measures, such as earnings. We present some formal econometric evidence in support of this prediction, using a panel of individual corporations. Evidence on some related predictions is also presented.
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aggregate conditions bias against equity bondholders business cycle business failures capital structure COMPUSTAT contemporaneous corporate debt countercyclical debt and equity debtholders dividend behavior dividend cut dividends relative dividends to interest Dun and Bradstreet econometric effect on dividends ep curve Equations 14 equilibrium equity cushion equity finance excessive leverage expected profits expected return exposure to macroeconomic Figure financial distress financial structure firm-specific variables firm's expected gain from cheating gc curves Glenn Hubbard idiosyncratic risk incentive constraint independent macroeconomic effect individual firm dividends interest payments lagged liquidation value macroeconomic conditions macroeconomic risk macroeconomic variable Mark Gertler NBER optimal financial Ordinary Least Squares output panel data payments to equltyholders possibility of renegotiation pure debt finance recessions Regression role of equity sharing aggregate risks signaling theories subsidy to debt substitute for equity tax bias tax considerations tax rate tax subsidy tax wedge vary with macroeconomic