The Journal of Finance

How Big Are the Tax Benefits of Debt?

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00277

John R. Graham

I integrate under firm‐specific benefit functions to estimate that the capitalized tax benefit of debt equals 9.7 percent of firm value (or as low as 4.3 percent, net of personal taxes). The typical firm could double tax benefits by issuing debt until the marginal tax benefit begins to decline. I infer how aggressively a firm uses debt by observing the shape of its tax benefit function. Paradoxically, large, liquid, profitable firms with low expected distress costs use debt conservatively. Product market factors, growth options, low asset collateral, and planning for future expenditures lead to conservative debt usage. Conservative debt policy is persistent.

Presidential Address: Corporate Finance and Reality

Published: 05/30/2022   |   DOI: 10.1111/jofi.13161

JOHN R. GRAHAM

This paper uses surveys to document CFO perspectives on corporate planning, investment, capital structure, payout, and shareholder versus stakeholder focus. Comparing policy decisions today to those 20 years ago, I find that companies employ decision rules that are conservative, sticky, and geared to time the market; rely on internal forecasts that are miscalibrated and considered reliable only two years ahead; and emphasize corporate objectives that focus increasingly on stakeholders and revenues. These practice of corporate finance themes can discipline academic models toward better explaining outcomes. Models of satisficing decision‐making or costly managerial biases align with many of the themes.

Herding among Investment Newsletters: Theory and Evidence

Published: 05/06/2003   |   DOI: 10.1111/0022-1082.00103

John R. Graham

A model is developed which implies that if an analyst has high reputation or low ability, or if there is strong public information that is inconsistent with the analyst's private information, she is likely to herd. Herding is also common when informative private signals are positively correlated across analysts. The model is tested using data from analysts who publish investment newsletters. Consistent with the model's implications, the empirical results indicate that a newsletter analyst is likely to herd on Value Line's recommendation if her reputation is high, if her ability is low, or if signal correlation is high.

Do Dividend Clienteles Exist? Evidence on Dividend Preferences of Retail Investors

Published: 05/16/2006   |   DOI: 10.1111/j.1540-6261.2006.00873.x

JOHN R. GRAHAM, ALOK KUMAR

We study stock holdings and trading behavior of more than 60,000 households and find evidence consistent with dividend clienteles. Retail investor stock holdings indicate a preference for dividend yield that increases with age and decreases with income, consistent with age and tax clienteles, respectively. Trading patterns reinforce this evidence: Older, low‐income investors disproportionally purchase stocks before the ex‐dividend day. Furthermore, among small stocks, the ex‐day price drop decreases with age and increases with income, consistent with clientele effects. Finally, consistent with the behavioral “attention” hypothesis, we document that older and low‐income investors purchase stocks following dividend announcements.

Tax Incentives to Hedge

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00187

John R. Graham, Clifford W. Smith

For corporations facing tax‐function convexity, hedging lowers expected tax liabilities, thereby providing an incentive to hedge. We use simulation methods to investigate convexity induced by tax‐code provisions. On average, the tax function is convex (although in approximately 25 percent of cases it is concave). Carrybacks and carryforwards increase the range of income with incentives to hedge; other tax‐code provisions have minor impacts. Among firms facing convex tax functions, average tax savings from a five percent reduction in the volatility of taxable income are about 5.4 percent of expected tax liabilities; in extreme cases, these savings exceed 40 percent.

Do Firms Hedge in Response to Tax Incentives?

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00443

John R. Graham, Daniel A. Rogers

There are two tax incentives for corporations to hedge: to increase debt capacity and interest tax deductions, and to reduce expected tax liability if the tax function is convex. We test whether these incentives affect the extent of corporate hedging with derivatives. Using an explicit measure of tax function convexity, we find no evidence that firms hedge in response to tax convexity. Our analysis does, however, indicate that firms hedge to increase debt capacity, with increased tax benefits averaging 1.1 percent of firm value. Our results also indicate that firms hedge because of expected financial distress costs and firm size.

Do Price Discreteness and Transactions Costs Affect Stock Returns? Comparing Ex‐Dividend Pricing before and after Decimalization

Published: 11/07/2003   |   DOI: 10.1046/j.1540-6261.2003.00617.x

John R. Graham, Roni Michaely, Michael R. Roberts

By the end of January 2001, all NYSE stocks had converted their price quotations from 1/8s and 1/16s to decimals. This study examines the effect of this change in price quotations on ex‐dividend day activity. We find that abnormal ex‐dividend day returns increase in the 1/16 and decimal pricing eras, relative to the 1/8 era, which is inconsistent with microstructure explanations of ex‐day price movements. We also find that abnormal returns increase in conjunction with a May 1997 reduction in the capital gains tax rate, as they should if relative taxation of dividends and capital gains affects ex‐day pricing.

Employee Stock Options, Corporate Taxes, and Debt Policy

Published: 11/27/2005   |   DOI: 10.1111/j.1540-6261.2004.00673.x

John R. Graham, Mark H. Lang, Douglas A. Shackelford

We find that employee stock option deductions lead to large aggregate tax savings for Nasdaq 100 and S&P 100 firms and also affect corporate marginal tax rates. For Nasdaq firms, including the effect of options reduces the estimated median marginal tax rate from 31% to 5%. For S&P firms, in contrast, option deductions do not affect marginal tax rates to a large degree. Our evidence suggests that option deductions are important nondebt tax shields and that option deductions substitute for interest deductions in corporate capital structure decisions, explaining in part why some firms use so little debt.

Does Corporate Diversification Destroy Value?

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00439

John R. Graham, Michael L. Lemmon, Jack G. Wolf

We analyze several hundred firms that expand via acquisition and/or increase their number of business segments. The combined market reaction to acquisition announcements is positive but acquiring firm excess values decline after the diversifying event. Much of the excess value reduction occurs because our sample firms acquire already discounted business units, and not because diversifying destroys value. This implies that the standard assumption that conglomerate divisions can be benchmarked to typical stand‐alone firms should be carefully reconsidered. We also show that excess value does not decline when firms increase their number of business segments because of pure reporting changes.

The Cost of Debt

Published: 11/09/2010   |   DOI: 10.1111/j.1540-6261.2010.01611.x

JULES H. Van BINSBERGEN, JOHN R. GRAHAM, JIE YANG

We use exogenous variation in tax benefit functions to estimate firm‐specific cost of debt functions that are conditional on company characteristics such as collateral, size, and book‐to‐market. By integrating the area between the benefit and cost functions, we estimate that the equilibrium net benefit of debt is 3.5% of asset value, resulting from an estimated gross benefit (cost) of debt equal to 10.4% (6.9%) of asset value. We find that the cost of being overlevered is asymmetrically higher than the cost of being underlevered and that expected default costs constitute only half of the total ex ante costs of debt.

Employee Costs of Corporate Bankruptcy

Published: 05/27/2023   |   DOI: 10.1111/jofi.13251

JOHN R. GRAHAM, HYUNSEOB KIM, SI LI, JIAPING QIU

An employee's annual earnings fall by 13% in the first full calendar year after her firm's bankruptcy, and the present value of lost earnings from bankruptcy to six years following bankruptcy is 87% of pre‐bankruptcy annual earnings. More worker earnings are lost in thin labor markets and among small firms. Ex ante compensating wage differentials for this “bankruptcy risk” are up to 2% of firm value for a firm whose credit rating falls from AA to BBB, comparable in magnitude to debt tax benefits. Thus, wage premia for expected costs of bankruptcy are sufficiently large to be an important consideration in capital structure decisions.

Debt, Leases, Taxes, and the Endogeneity of Corporate Tax Status

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.55404

John R. Graham, Michael L. Lemmon, James S. Schallheim

We provide evidence that corporate tax status is endogenous to financing decisions, which induces a spurious relation between measures of financial policy and many commonly used tax proxies. Using a forward‐looking estimate of before‐financing corporate marginal tax rates, we document a negative relation between operating leases and tax rates, and a positive relation between debt levels and tax rates. This is the first unambiguous evidence supporting the hypothesis that low tax rate firms lease more, and have lower debt levels, than high tax rate firms.