SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

Abstract: The effect of tax discrimination of equity capital on the simultaneous choice of financial structure and operational risk is studied in a model with symmetrical information, risk neutral investors, bankruptcy costs and small open economy assumptions. Taxes are either proportional to the amount of equity capital or to the realized return on equity capital. It is shown that the optimal debt ration is always increasing in the tax rate. The optimal operational risk is decreasing in the tax rate for low and moderate tax rates but increasing for high tax rates (implicating high default probabilities). These high tax rates tend to be above the Laffer curve maximum. The probability of default is usually increasing in the tax rate.

Keywords: Corporate taxation; capital structure; operational risk

JEL-codes: G32; H32

26 pages, January 1994

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