Hedging Employee Stock Options, Corporate Taxes, and Debt

This study explores two effects of employee stock options on tax incentives to issue debt. The deduction of option from taxable income creates a non-debt tax shield, reducing the incentive to issue debt. In contrast, the grant of options also creates a demand for hedging unexpected stock price increases, and firms have a taxbased incentive to hedge by borrowing to repurchase shares. Empirical tests for a sample of large S&P 500 firms from 1995 to 2001 present evidence consistent with both effects, and the increase in debt through hedging more than offsets the effect from reducing marginal tax rates for high tax rate firms.