It is well known that firms are more likely to issue equity when their market values are high, relative to book and past market values, and to repurchase equity when their market values are low. We document that the resulting effects on capital structure are very persistent. As a consequence, current capital structure is strongly related to historical market values. The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market.

We test the dividend and leverage predictions of the tradeoff and pecking order models. As both models predict, more profitable firms have higher long-term dividend payouts, and firms with more investments have lower payouts. Confirming the pecking order model but contradicting the tradeoff model, more profitable firms are less levered. Firms with more investment opportunities are also less levered, which is in line with the tradeoff model and a complex version of the pecking order model. Firms with more investments have lower long-term dividend payouts, but dividends do not vary to accommodate short-term variation in investment. Confirming the pecking order model, short-term variation in investment and earnings is mostly absorbed by variation in debt. * Graduate School of Business, University of Chicago (Fama) and Sloan School of Management, MIT (French). The finance literature offers two competing models of financing decisions. In the tradeoff model, firms identify their optimal l...

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P. Szegö is at the Università de Roma 'La Sapienza. ' The opinions expressed do not necessarily reflect those of the Board of Governors or its staff. The authors thank the Wharton Financial Institutions Center for sponsoring the conference on which the special

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.

This paper reviews the theory and evidence regarding the impact of taxation on corporate financial policy. Starting from a basic characterization of the classical corporate income tax and its effects, the analysis focuses on three areas of research: equity policy, debt-equity decisions, and choices regarding ownership structure and organizational form. The discussion stresses the distinction between nominal and more fundamental financial differences for example, in the relationship between borrowing and leasing and that financial policy involves choices not only among different underlying policies but also among characterizations of a given policy. The final section offers some brief reflections on the implications of continuing financial innovation.

We examine the importance of stockholder}bondholder con#icts in capital-structure choice. Numerical techniques are used to compute the expected wealth transfer between stockholders and bondholders when a "rm adopts a new project. We characterize the set of positive NPV projects that stockholders prefer to ignore and the set of negative NPV projects that stockholders want to accept. The results illustrate how these distortions vary with "rm and project characteristics. We also estimate the impact of stockholder}bondholder con#icts on investment decisions for 23 di!erent "rms and examine

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Multiple activities may be separated financially, allowing each to optimize its financial structure, or combined in a firm with a single optimal financial structure. We consider activities with nonsynergistic operational cash flows, and examine the purely financial benefits of separation versus merger. The magnitude of financial synergies depends upon tax rates, default costs, relative size, and the riskiness and correlation of cash flows. Contrary to accepted wisdom, financial synergies from mergers can be negative if firms have quite different risks or default costs. The results provide a rationale for structured finance techniques such as asset securitization and project finance. DECISIONS THAT ALTER THE SCOPE of the firm are among the most important faced by management, and among the most studied by academics. Mergers and spinoffs are classic examples of such decisions. More recently, structured finance has seen explosive growth: Asset securitization exceeded $6.8 trillion in 2004, and Esty and Christov (2002) report that in 2001, more than half of capital investments with costs exceeding $500 million were financed on a separate project basis. 1 Yetfinancial theory has made little headway in explaining structured finance. Positive or negative operational synergies are often cited as a prime motivation for decisions that change the scope of the firm. A rich literature addresses the roles of economies of scope and scale, market power, incomplete contracting, property rights, and agency costs in determining the optimal boundaries of the firm. 2 But operational synergies are difficult to identify in the case of asset securitization and structured finance.

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, the median marginal tax rate is 31 percent when option deductions are ignored but falls to 5 percent when one accounts for the deductions. For S&P firms, however, option deductions do not affect marginal tax rates to a large degree. In the spirit of DeAngelo and Masulis (1980), option deductions are important nondebt tax shields that can affect corporate policies. We find evidence consistent with option deductions substituting for interest deductions in corporate capital structure decisions. This evidence may explain in part why some firms use so little debt.