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Effects of Classifying Equity or Debt on the Value of the Firm under Tax Asymmetry

Published online by Cambridge University Press:  06 April 2009

Ivan E. Brick  and
Lawrence Fisher
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Abstract

This paper examines the effect of classifying a firm's equity or debt into subclasses of unequal seniority on the total expected tax burden of the firm and its security holders in a world with no agency and no bankruptcy costs. It is shown that, when positive income is taxed at a higher rate than that allowed on realized capital losses, expected taxes are minimized and the value of the firm is maximized if the firm has only one class of equity and, at most, one class of debt. This result helps to explain the common practice of issuing corporate bonds under open indentures. In fact, our empirical results indicate that before the advent of a differentiated capital gains tax in 1921, a great majority of publicly traded long-term industrial bonds were issued under closed indentures. By 1951, nearly all such debt was issued under single indentures (i.e., there was only one class of creditor).

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 22 , Issue 4 , December 1987 , pp. 383 - 399
Copyright
Copyright © School of Business Administration, University of Washington 1987

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