According to conventional wisdom, the use of debt financing offsets the negative effect of historical cost depreciation on the firm's real cash flows. This effect derives from the following: According to tax law, the debtor firm can claim the entire nominal interest payment as a tax deduction notwithstanding the fact that the nominal interest payment includes a component which represents the return of real capital to the firm's bondholders.Maher and Nantell (Journal of Accounting Research, Spring 1983, pp. 329-340) claim to show that, given Miller's equilibrium tax rates, the use of debt financing does not ameliorate but rather aggravates the deleterious effect of historical cost depreciation. The aim of this paper is to criticize their conclusion. It is shown that their result derives, not from Miller's equilibrium tax rates, but rather from their implicit assumption regarding the behaviour of bond interest rates in the presence of inflation. They assume that bondholders are fully compensated on a postpersonal tax basis for the effect of inflation. We argue that it is implausible to assume that bondholders are completely insulated from the effects of inflation while shareholders suffer wealth losses due to inflation. A more plausible assumption is that both groups of investors are affected by inflation. Consistent with the theoretical result of Nielsen (Journal of Monetary Economics, 1981, pp. 261-2701, we assume that the real post-personal tax rate of return on the firm's bonds declines in the presence of inflation. Given this stipulation. we show that traditional wisdom is upheld, e. debt financing ameliorates the negative effect of historical cost depreciation.
scite is a Brooklyn-based organization that helps researchers better discover and understand research articles through Smart Citations–citations that display the context of the citation and describe whether the article provides supporting or contrasting evidence. scite is used by students and researchers from around the world and is funded in part by the National Science Foundation and the National Institute on Drug Abuse of the National Institutes of Health.
hi@scite.ai
10624 S. Eastern Ave., Ste. A-614
Henderson, NV 89052, USA
Copyright © 2024 scite LLC. All rights reserved.
Made with 💙 for researchers
Part of the Research Solutions Family.