- In this study, the relationship between tax rate changes and capital structure changes is examined via corporate merger. A direct relationship between changes in tax rates and capital structures has been hypothesized in the finance literature; however, no direct empirical evidence is currently available. The present study, first, paves the way for such direct testings by formulating a model which shows a merger to be a situation whereby two firms may use the tax code to reduce the effective tax rate and debt level of the merged firm as compared to that of the constituent firms.
This is accomplished by extending a well-known capital structure model, which incorporates tax shield substitutes for debt, to the merger situation. The current model shows that the existence of tax shield substitutes for debt such as depreciation and investment tax credits, under certain circumstances, increases the amount of usable deductions and thus reduces the amount of cash flow exposed to corporate taxes. The resulting lower effective tax rate is shown never to make the shareholders worse off and to reduce the corporations' use of debt (normative behaviour). Thus the present model results in the following readily testable hypothesis: Firms which exhibit normative (non-normative) behaviour will experience abnormal gains (losses) due to the merger.
The study then presents empirical estimates of the stock market's reaction to mergers that result in (1) a direct and indirect relationship between changes in effective tax rate and debt ratio, and (2) an increase or decrease in the effective tax rate and debt ratio. The evidence indicates, in general, and (a) the shareholders of the combined firms are always made significantly better off by the merger regardless of its impact on the effective tax rate and/or debt ratio, (b) the abnormal returns are confined to the announcement month, and (c) the majority of the abnormal returns accrue to the acquired firms' shareholders.
Although the last two findings are what we would expect, the first one appears not to be symmetric with the predictions of the model or with other recent research that documents a direct relationship between the sign of the leverage change and the returns to shareholders. The current findings suggest that the precise nature of the information contained in the effective tax rate and debt ratio changes is undefined, and that the observed lack of symmetry makes it impossible to support the hypothesis developed by the model.
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- Dissertation Note:
- Ph.D. The Pennsylvania State University 1985.
- Source: Dissertation Abstracts International, Volume: 46-09, Section: A, page: 2765.
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