The Capital Structure and Lifo/Fifo Choices : Tests of Cash-Flow Signaling and Tax-Shield Substitution

This research empirically examines the interaction between the choices of inventory accounting method and capital structure through a parsimonious test of the predictions from the signaling model of Hughes Schwartz and Thakor (1994). We find that the debt of firms remaining at FIFO decreases after some firms switch to LIFO and that firms remaining at FIFO have higher pre-switch debt levels than firms switching to LIFO. These results are consistent with the predictions of Hughes et al. and the conclusion that among firms using the same inventory accounting method managers use debt to signal expected future cash flows. We also find that managers of firms adopting LIFO reduce debt. Although this is not consistent with the prediction of Hughes et al. it is consistent with the competing prediction of tax-shield substitution theory that managers of firms adopting LIFO decrease debt to compensate for the increased probability of tax exhaustion brought about by an increase in cost of goods sold