Agency Costs, Taxes and Debt: The UK Evidence

Abstract

This paper provides an empirical examination of the impact of the corporation tax and the agency costs on firms' capital structure decisions. Our evidence suggests that the agency costs are the main determinants of corporate borrowing. Consistent with the agency theory, we find that firms that have fewer growth options have more debt in their capital structure. Moreover, our results show that debt mitigates the free cash flow problem and that firms that are more likely to be diversified and less prone to bankruptcy are highly geared. In addition, we find that, in the long-run, companies that are tax exhausted exhibit significantly lower debt ratios than tax-paying firms. However, in the short-run, firms' capital structure decisions are not affected by taxation.

JEL Classification: G32