Corporate taxes, changing risk, and wealth transfers between shareholders, lenders, and the taxman

This paper examines how risk and corporate taxes jointly affect the value of the debt and equity of a firm. We view the total pretax value of the firm as being divided between the taxman, lenders, and shareholders, and examine how increasing the risk of a leveraged firm, with no change in its pretax value, affects these claimants. We show that shareholders may gain while the taxman loses, or vice versa, or that both gain at the expense of lenders. The outcome depends on several factors including the ranking of the claims of the taxman and lenders. The analysis is extended to investments which expand the firm; here our conclusions are at variance with some frequently expressed views on possible tax advantages of merging. We obtain different conclusions because we make allowance for the diversification effects of merging on the value of the debt claims. A careful examination of this requires a precise mathematical formulation of the values of the tax, debt, and equity claims using option-pricing techniques.