Publication Type

Journal Article

Version

publishedVersion

Publication Date

6-2006

Abstract

Term structure models have often been criticized for failing to explain satisfactorily the yield spread between corporate and Treasury bonds. A potential problem is that the personal tax effect is ignored in these models. In this paper, we employ a structural model to investigate the role of personal taxes on both debt and equity returns in capital structure decisions and assess their impact on corporate bond yield spreads. It is shown that personal taxes affect the firm's optimal capital structure, and the tax premium explains a substantial portion of yield spreads, especially for high-grade bonds. The predictive ability of the model for yield spreads is much improved when personal tax effects are accounted for. In controlling for the liquidity effect, we obtain implied personal income tax rates closely in line with Graham's (1999) estimates.

Keywords

structural approach, endogenous default, personal taxes, yield spread, risk neutrality

Discipline

Corporate Finance | Portfolio and Security Analysis

Research Areas

Finance

Publication

Management Science

Volume

52

Issue

6

First Page

939

Last Page

954

ISSN

0025-1909

Identifier

10.1287/mnsc.1050.0497

Publisher

INFORMS

Comments

Published version made available in SMU repository with permission of INFORMS, 2014, February 28

Additional URL

https://doi.org/10.1287/mnsc.1050.0497

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