1. Chapter 15 Debt and Taxes

2. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-2 15.1 The Interest Tax Deduction Corporations pay taxes on their profits after interest payments are deducted. Thus, interest expense reduces the amount of corporate taxes. This creates an incentive to use debt.

3. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-3 15.1 The Interest Tax Deduction (cont'd) Consider Macy’s which had earnings before interest and taxes of approximately $2.5 billion in 2011, and interest expenses of about $430 million. Macy’s marginal corporate tax rate was 35%. Macy’s net income in 2011 was lower with leverage than it would have been without leverage.

4. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-4 15.1 The Interest Tax Deduction (cont'd) Macy’s debt obligations reduced the value of its equity. But, the total amount available to all investors was higher with leverage.

5. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-5 15.1 The Interest Tax Deduction (cont'd) Interest Tax Shield –The reduction in taxes paid due to the tax deductibility of interest In Macy’s case, the gain is equal to the reduction in taxes with leverage: $875 million − $725 million = $150 million. The interest payments provided a tax savings of 35% × $430 million = $150 million.

6. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-6 The Interest Tax Shield and Firm Value (cont'd) MM Proposition I with Taxes –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.

7. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-7 Value of the Firm

8. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-8 The Interest Tax Shield with Permanent Debt Suppose a firm borrows debt D and keeps the debt permanently. If the firm’s marginal tax rate is  c, and if the debt is riskless with a risk-free interest rate r f, then the interest tax shield each year is  c × r f × D, and the tax shield can be valued as a perpetuity.

9. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-9 The Weighted Average Cost of Capital with Taxes With tax-deductible interest, the effective after-tax borrowing rate is r(1 −  c ) and the weighted average cost of capital becomes

10. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-10 Figure 15.2 The WACC with and without Corporate Taxes How does the reduction of WACC (due to taxes) impact the value of the firm?

11. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-11 Value of the Firm

12. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-12 Textbook Example 15.3

13. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-13 15.3 Recapitalizing to Capture the Tax Shield Recapitalizing means to change the capital structure. How does this impact shareholders? Assume that Midco Industries wants to boost its stock price. The company currently has 20 million shares outstanding with a market price of $15 per share and no debt. Midco has had consistently stable earnings, and pays a 35% tax rate. Management plans to borrow $100 million on a permanent basis and they will use the borrowed funds to repurchase outstanding shares.

14. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-14 The Tax Benefit Without leverage –V U = (20 million shares) × ($15/share) = $300 million If Midco borrows $100 million using permanent debt, the present value of the firm’s future tax savings is –PV(interest tax shield) =  c D = 35% × $100 million = $35 million

15. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-15 The Tax Benefit (cont'd) Thus the total value of the levered firm will be –V L = V U +  c D = $300 million + $35 million = $335 million Because the value of the debt is $100 million, the value of the equity is –E = V L − D = $335 million − $100 million = $235 million

16. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-16 The Tax Benefit (cont'd) Although the value of the shares outstanding drops to $235 million, shareholders will also receive the $100 million that Midco will pay out through the share repurchase. In total, they will receive the full $335 million, a gain of $35 million over the value of their shares without leverage.

17. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-17 The Share Repurchase Assume Midco repurchases its shares at the current price of $15/share. The firm will repurchase 6.67 million shares. –$100 million ÷ $15/share = 6.67 million shares It will then have 13.33 million shares outstanding. –20 million − 6.67 million = 13.33 million

18. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-18 The Share Repurchase (cont'd) The total value of equity is $235 million; therefore the new share price is $17.625/share. –$235 million ÷ 13.33 million shares = $17.625 Shareholders that keep their shares earn a capital gain of $2.625 per share. –$17.625 − $15 = $2.625

19. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-19 The Share Repurchase (cont'd) The total gain to shareholders is $35 million. –$2.625/share × 13.33 million shares = $35 million If the shares are worth $17.625/share after the repurchase, why would shareholders tender their shares to Midco at $15/share? How can the company get shareholders to participate??

20. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-20 No Arbitrage Pricing If investors could buy shares for $15 immediately before the repurchase, and they could sell these shares immediately afterward at a higher price, this would represent an arbitrage opportunity. Realistically, the value of the Midco’s equity will rise immediately from $300 million to $335 million after the repurchase announcement. With 20 million shares outstanding, the share price will rise to $16.75 per share. –$335 million ÷ 20 million shares = $16.75 per share

21. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-21 No Arbitrage Pricing (cont'd) With a repurchase price of $16.75, the shareholders who tender their shares and the shareholders who hold their shares both gain $1.75 per share as a result of the transaction. –$16.75 − $15 = $1.75 The benefit of the interest tax shield goes to all 20 million of the original shares outstanding for a total benefit of $35 million. –$1.75/share × 20 million shares = $35 million 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.

22. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-22 15.4 Personal Taxes The cash flows to investors are typically taxed twice. –Once at the corporate level and then again when they receive their interest or divided payment. For individuals: –Interest payments received from debt are taxed as income. –Equity investors also must pay taxes on dividends and capital gains.

23. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-23 Including Personal Taxes in the Interest Tax Shield The amount of money an investor will pay for a security depends on the the cash flows the investor will receive after all taxes have been paid. Personal taxes reduce the cash flows to investors and can offset some of the corporate tax benefits of leverage.

24. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-24 Including Personal Taxes in the Interest Tax Shield (cont'd) The actual interest tax shield depends on both corporate and personal taxes that are paid. To determine the true tax benefit of leverage, the combined effect of both corporate and personal taxes needs to be evaluated.

25. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-25 Including Personal Taxes in the Interest Tax Shield (cont'd) –When there are no personal taxes on debt income ( i = 0) or when the personal tax rates on debt and equity income are the same ( i =  e ), the formula reduces to * =  c. –When equity income is taxed less heavily ( e is less than  i ), then * is less than  c.

26. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-26 Valuing the Interest Tax Shield with Personal Taxes (cont'd) 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.

27. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-27 Value of the Firm

28. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-28 15.5 Optimal Capital Structure with Taxes Do Firms Prefer Debt? –When firms raise new capital from investors, they do so primarily by issuing debt. –In most years aggregate equity issues are negative, meaning that on average, firms are reducing the amount of equity outstanding by buying shares.

29. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-29 15.5 Optimal Capital Structure with Taxes (cont'd) Do Firms Prefer Debt? –While firms seem to prefer debt when raising external funds, not all investment is externally funded. –Most investment and growth is supported by internally generated funds. Even though firms have not issued new equity, the market value of equity has risen over time as firms have grown. For the average firm, the result is that debt as a fraction of firm value has varied in a range from 30–45%.

30. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-30 15.5 Optimal Capital Structure with Taxes (cont'd) Do Firms Prefer Debt? –The use of debt varies greatly by industry. –Firms in growth industries like biotechnology or high technology carry very little debt, while airlines, automakers, utilities, and financial firms have high leverage ratios.

31. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-31 Limits to the Tax Benefit of Debt The optimal level of leverage from a tax saving perspective is the level such that interest equals EBIT. –At the optimal level of leverage, the firm shields all of its taxable income and it does not have any tax-disadvantaged excess interest.

32. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-32 Limits to the Tax Benefit of Debt (cont'd) However, it is unlikely that a firm can predict its future EBIT (and the optimal level of debt) precisely. –If there is uncertainty regarding EBIT, then there is a risk that interest will exceed EBIT. As a result, the tax savings for high levels of interest falls, possibly reducing the optimal level of the interest payment.

33. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-33 Growth and Debt Growth will affect the optimal leverage ratio. –To avoid excess interest, a firm with positive earnings should have a level of debt such that interest payments are below its expected taxable earnings.

34. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-34 Growth and Debt (cont'd) 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. 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.

35. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-35 Other Tax Shields 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.

36. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-36 The Low Leverage Puzzle The figure on the following slide reveals two important patterns. –Firms have used debt to shield a greater percentage of their earnings from taxes in more recent years (mirroring the increase in the effective tax advantage of debt). –Firms have far less leverage than our analysis of the interest tax shield would predict.

37. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-37 The Low Leverage Puzzle (cont'd) Firms worldwide have similar low proportions of debt financing. –Although the corporate tax codes are similar across all countries in terms of the tax advantage of debt, personal tax rates vary more significantly, leading to greater variation in *.

38. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-38 The Low Leverage Puzzle (cont'd) It would appear that firms, on average, are under-leveraged. However, it is hard to accept that most firms are acting suboptimally. –In reality, there is more to the capital structure story than discussed so far.

39. Copyright ©2014 Pearson Education, Inc. All rights reserved.15-39 The Low Leverage Puzzle (cont'd) A key item missing from the analysis thus far is that increasing the level of debt increases the probability of bankruptcy. If bankruptcy is costly, these costs might offset the tax advantages of debt financing.