The Tax Disadvantage of Debt

This study identifies a tax disadvantage of debt that arises when a firm’s business model fails and it liquidates its assets at a loss. If the outstanding debt is greater than or equal to the salvage value of the firm’s assets, the firm will not have assets to generate income to use the loss generated by the liquidation. Furthermore, tax law restrictions limit the ability of new investors or another firm to acquire the failed firm and make use of its net operating loss carryover. Anticipating this situation, the firm issues debt that is less than the salvage value of its assets, even if the probability of liquidation in the short-run is very low. If the probability of liquidation in the short-run is not too low, an all-equity capital structure is optimal