The Substitutability of Debt and Non-debt Tax Shields and their Influence on Financial Decisions: An Empirical Analysis

The influence of taxes on financial decisions has been a focus of an enormous body of corporate finance research for decades. There is no doubt that the deductibility of interest paid on debt by a company, shields that company, shields that company from part of the tax burden. This is probably one of the major reasons for the used of debt financing for some companies, and could possibly be one of the sources of the creation of the net present value of debt financing. However, the interest tax shield creates incentive to employ debt financing only if a firm has enough taxable income to shield. The existence of other (non-debt) tax shields like accelerated depreciation allowances on investments, tax loss carry-forwards (or backwards), and expenses research and development (R&D) expenditures, diminishes that attractiveness of interest tax shields and creates a substitution effect between these two types of tax shields. Theoretical extensions of the basic non-debt tax shields theory have suggested that even this substitution effect between the two types of tax shields is not that straight forward. In this study, empirical investigations are conducted using UK companies' panel data to validate the extent theories surrounding the substitutability of debt and non-debt tax shields. Consistent with the basic theoretical predictions a strong significant inverse relation is evident between gearing (debt tax shields) and non-debt tax shields. Results also lend some support to the extensions to the basic theory that firms with lower levels of non-debt tax shields need not have higher gearing, and also that the degree of substitutability changes depending on the level of investment (or production process) for a given firm. African Journal of Finance and Management Vol.12(2) 2004: 46-6