478 Part Five Payout Policy and Capital Structure
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avoids extreme predictions and rationalizes moderate debt ratios. Also, if you ask financial
managers whether their firms have target debt ratios, they will usually say yes—although the
target is often specified not as a debt ratio but as a debt rating. For example, the firm might
manage its capital structure to maintain a single-A bond rating. Ratio or rating, a target is
consistent with the trade-off theory.^21
But what are the facts? Can the trade-off theory of capital structure explain how companies
actually behave?
The answer is “yes and no.” On the “yes” side, the trade-off theory successfully explains
many industry differences in capital structure. High-tech growth companies, whose assets are
risky and mostly intangible, normally use relatively little debt. Airlines can and do borrow
heavily because their assets are tangible and relatively safe.^22
On the “no” side, there are some things the trade-off theory cannot explain. It cannot
explain why some of the most successful companies thrive with little debt. Think of Johnson
& Johnson, which, as Table 18.4A shows, has little debt. Granted, Johnson & Johnson’s most
valuable assets are intangible, the fruits of its research and development. We know that intan-
gible assets and conservative capital structures go together. But Johnson & Johnson also has
a very large corporate income tax bill (about $4.2 billion in 2014) and the highest possible
credit rating. It could borrow enough to save tens of millions of dollars without raising a whis-
ker of concern about possible financial distress.
Johnson & Johnson illustrates an odd fact about real-life capital structures: The most prof-
itable companies commonly borrow the least.^23 Here the trade-off theory fails, for it predicts
exactly the reverse. Under the trade-off theory, high profits should mean more debt-servicing
capacity and more taxable income to shield and so should give a higher target debt ratio.^24
In general, it appears that public companies rarely make major shifts in capital structure just
because of taxes,^25 and it is hard to detect the present value of interest tax shields in firms’ mar-
ket values.^26 Also, there are large, long-lived differences between debt ratios of firms in the same
industry, even after controlling for attributes that the trade-off theory says should be important.^27
A final point on the “no” side for the trade-off theory: Debt ratios today are no higher than
they were in the early 1900s, when income tax rates were low (or zero). Debt ratios in other
industrialized countries are equal to or higher than those in the U.S. Many of these countries
have imputation tax systems, which should eliminate the value of the interest tax shields.^28(^21) See J. Graham and C. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial
Economics 60 (May/June 2001), pp. 187–244.
(^22) We are not suggesting that all airline companies are safe; many are not. But aircraft can support debt where airlines cannot. If
Fly-by-Night Airlines fails, its planes retain their value in another airline’s operations. There’s a good secondary market in used air-
craft, so a loan secured by aircraft can be well protected even if made to an airline flying on thin ice (and in the dark).
(^23) For example, in an international comparison Wald found that profitability was the single largest determinant of firm capital struc-
ture. See J. K. Wald, “How Firm Characteristics Affect Capital Structure: An International Comparison,” Journal of Financial
Research 22 (Summer 1999), pp. 161–187.
(^24) Here we mean debt as a fraction of the book or replacement value of the company’s assets. Profitable companies might not borrow a
greater fraction of their market value. Higher profits imply higher market value as well as stronger incentives to borrow.
(^25) Mackie-Mason found that taxpaying companies are more likely to issue debt (vs. equity) than nontaxpaying companies. This shows
that taxes do affect financing choices. However, it is not necessarily evidence for the trade-off theory. Look back to Section 18-2,
and note the special case where corporate and personal taxes cancel to make debt policy irrelevant. In that case, taxpaying firms
would see no net tax advantage to debt: corporate interest tax shields would be offset by the taxes paid by investors in the firm’s debt.
But the balance would tip in favor of equity for a firm that was losing money and reaping no benefits from interest tax shields. See
J. Mackie-Mason, “Do Taxes Affect Corporate Financing Decisions?” Journal of Finance 45 (December 1990), pp. 1471–1493.
(^26) A study by E. F. Fama and K. R. French, covering over 2,000 firms from 1965 to 1992, failed to find any evidence that interest tax
shields contributed to firm value. See “Taxes, Financing Decisions and Firm Value,” Journal of Finance 53 (June 1998), pp. 819–843.
(^27) M. L. Lemmon, M. R. Roberts, and J. F. Zender, “Back to the Beginning: Persistence and the Cross-Section of Corporate Capital
Structure,” Journal of Finance 63 (August 2008), pp. 1575–1608.
(^28) We described the Australian imputation tax system in Section 16-5. Look again at Table 16.2, supposing that an Australian cor-
poration pays A$10 of interest. This reduces the corporate tax by A$3.00; it also reduces the tax credit taken by the shareholders by
A$3.00. The final tax does not depend on whether the corporation or the shareholder borrows.
You can check this by redrawing Figure 18.2 for the Australian system. The corporate tax rate Tc will cancel out. Since income
after all taxes depends only on investors’ tax rates, there is no special advantage to corporate borrowing.