1. Capital Structure I Debt and Taxes

While leverage increases the risk and cost of capital of the firm’s equity, the firm’s weighted average cost of capital (WACC), total value, and share price are unaltered by a change in leverage. That is, in a perfect capital market, a firm’s choice of capital structure is unimportant.

Because corporations pay taxes on their profits after interest payments are deducted, interest expenses reduce the amount of corporate tax firms must pay. This feature of the tax code creates an incentive to use debt.

It might seem odd that a firm can be better off with leverage even though its earnings are lower. But recall from Chapter 14 that the value of a firm is the total amount it can raise from all investors, not just equity holders. Because leverage allows the firm to pay out more in total to its investors—including interest payments to debt holders—it will be able to raise more total capital initially.

In general, the gain to investors from the tax deductibility of interest payments is referred to as the interest tax shield. The interest tax shield is the additional amount that a firm would have paid in taxes if it did not have leverage.

The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt:

They are discounted at a rate that corresponds to its risk.

Given a 21% corporate tax rate, it implies that for every $1 in new permanent debt that the firm issues, the value of the firm increases by $0.21.

The (After-Tax) WACC represents the effective cost of capital to the firm, after including the benefits of the interest tax shield. It is therefore lower than the pre-tax WACC, which is the average return paid to the firm’s investors.

The higher the leverage the lower the WACC (The firm exploits the tax advantage of debt more)

When a firm makes a significant change to its capital structure, the transaction is called a recapitalization (or simply a “recap”). In Chapter 14, we introduced a leveraged recapi- talization in which a firm issues a large amount of debt and uses the proceeds to pay a special dividend or to repurchase shares.

Once investors know the recap will occur, the share price will rise immediately to a level that reflects the $21 million value of the interest tax shield that the firm will receive. That is, the value of the Midco’s equity will rise immediately from $300 million to $321 million. With 20 million shares outstanding, the share price will rise to $16.05 per share ($321m/20m).

With a repurchase price of $16.05, the shareholders who tender their shares and the shareholders who hold their shares both gain $16.05 - $15 = $1.05 per share as a result of the transaction. The benefit of the interest tax shield goes to all 20 million of the original shares outstanding for a total benefit of $1.05/share * 20 million shares = $21 million. In other words,

Note that the share price rises at the announcement of the recap. This increase in the share price is due solely to the present value of the (anticipated) interest tax shield. Thus, even though leverage reduces the total market capitalization of the firm’s equity, sharehold- ers capture the benefits of the interest tax shield upfront.8

When securities are fairly priced, the original shareholders of a firm capture the full benefit of the interest tax shield from an increase in leverage.

-> No shareholders will be willing to sell their shares unless the repurchase price is at least as high as the share price after the transaction; otherwise, they would be better off waiting to sell their shares.

In the presence of corporate taxes, the tax shield is an asset.

Unfortunately for investors, after they receive the cash flows, they are generally taxed again. For individuals:

-interest payments received from debt are taxed as income

-Equity investors also must pay taxes on dividends and capital gains.

Historically, interest income has been taxed more heavily than capital gains from equity

The value of a firm is equal to the amount of money the firm can raise by issuing securities. The amount of money an investor will pay for a security ultimately depends on the benefits the investor will receive—namely, the cash flows the investor will receive after all taxes have been paid. Thus, just like corporate taxes, personal taxes reduce the cash flows to investors and diminish firm value. As a result, the actual interest tax shield depends on the reduction in the total taxes (both corporate and personal) that are paid.

-When stocks or bonds are held in retirement savings accounts or pensions funds

-Holding period: Short holding period fails to qualify for lower tax rates on equity

From these investors, the tax advantage of debt is simply the corporate tax rate

Personal taxes have a similar, but indirect, effect on the firm’s weighted average cost of capital. While we still compute the WACC using the corporate tax rate tc as in Eq. 15.5, with personal taxes the firm’s equity and debt costs of capital will adjust to compensate investors for their respective tax burdens. The net result is that a personal tax disadvantage for debt causes the WACC to decline more slowly with leverage than it otherwise would.

While firms seem to prefer debt when raising external funds, not all investment is exter- nally funded. As Figure 15.5 also shows, capital expenditures greatly exceed firms’ external financing, implying that most investment and growth is supported by internally gener- ated funds, such as retained earnings. Thus, even though firms have not issued new equity, the market value of equity has risen over time as firms have grown.

-Growth industries like biotech or high tech have very little debt and large cash reserves

-Wireless telecomms, real estat firms, trucking and automative firm und utilities have high leverage ratios

Large corporations cannot deduct inter- est exceeding 30% of their earnings before interest, taxes, depreciation, and amortization (EBITDA), and this limit drops to 30% of EBIT after 2021.

Thus, no corporate tax benefit arises from incurring interest payments that regularly exceed the income limit. And, because interest payments constitute a tax disadvantage at the investor level as discussed in Section 15.4, investors will pay higher personal taxes with excess leverage, making them worse off.

The optimal level of leverage from a tax saving perspective is the level such that interest just equals the income limit.

The firm shields all of its taxable in- come, and it does not have any tax-disadvantaged excess interest.

In general, as a firm’s interest expense approaches its expected taxable earnings, the marginal tax advan- tage of debt declines, limiting the amount of debt the firm should use.

Even for a firm with positive earnings, growth will affect the optimal leverage ratio. To avoid excess interest, this type of firm should have debt with interest payments that are sufficiently below its expected taxable earnings.

So, from a tax perspective, the firm’s optimal level of debt is proportional to its current earnings. However, the value of the firm’s equity will depend on the growth rate of earnings:

The higher the growth rate, the higher the value of equity is (and equivalently, the higher the firm’s price-earnings multiple is). As a result, the optimal proportion of debt in the firm’s capital structure [D/(E + D)] will be lower, the higher the firm’s growth rate.

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There are numerous provisions in the tax laws for deductions and tax credits, such as depreciation, investment tax credits, carryforwards of past operating losses, etc.

To the extent that a firm has other tax shields, its taxable earnings will be reduced, and it will rely less heavily on the interest tax shield.