Tax Benefits of Debt and Debt Financing in Korea*

Abstract

In this study, we attempt to determine whether or not Korean firms have failed to fully utilize the tax benefits of debt, particularly in the aftermath of the 1997 Asian financial crisis. Results suggest that underleveraged firms lost significant tax savings that would have been available had they increased debt levels to their kink. The incremental tax benefit in 2008 is estimated to be as large as 5.2% (2.1%) of firm value prior to (after) the personal tax penalty. These firms low leverage, however, seems reasonable when we consider the financial distress costs. Increases in expected default costs offset the majority of potential tax savings after the financial crisis.