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Università Bocconi, A.A: 2005-2006 1 Mec – Comparative public economics 1 Università Bocconi A.A. 2005-2006 Comparative public economics Giampaolo Arachi.

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Presentation on theme: "Università Bocconi, A.A: 2005-2006 1 Mec – Comparative public economics 1 Università Bocconi A.A. 2005-2006 Comparative public economics Giampaolo Arachi."— Presentation transcript:

1 Università Bocconi, A.A: 2005-2006 1 Mec – Comparative public economics 1 Università Bocconi A.A. 2005-2006 Comparative public economics Giampaolo Arachi

2 Università Bocconi, A.A: 2005-2006 2 Mec – Comparative public economics 2 References M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T. Shevlin (SWEMS), Taxes and business strategy: a planning approach, Pearson Prentice Hall, third edition, 2005, ch.7

3 Università Bocconi, A.A: 2005-2006 3 Mec – Comparative public economics 3 Tax planning problem Subject: corporation Statutory corporate tax rate: 40% Liquidity: $30 millions Available strategies: –Invest in bonds –Invest in preferred stocks –Issue bonds –Issue preferred stocks Rates: bonds 8%, dividend yield on preferred 6% Taxation: –bonds return fully taxable, interest deductible –Dividend yield deductibe at 20%, dividend distribution non deductible

4 Università Bocconi, A.A: 2005-2006 4 Mec – Comparative public economics 4 Traditional preferred stocks Features: fixed yields no or limited voting rights preferences over common stocks in payment of dividend and in liquidation Taxation Taxed as equity Issuer cannot deduct preferred stock dividends In U.S. if the holder is a corporation the dividend is only partially taxable

5 Università Bocconi, A.A: 2005-2006 5 Mec – Comparative public economics 5 Tax planning analysis Implicit tax rate on preferred = (0.08 - 0.06)/0.08 = 0.25 Explicit tax rate: (R a -R*)/Rb = (0.06 – 0.05647) = 0.0441 R* from equilibrium condition.08 (1 – t) =.06 (1 – 0.2t)  t=29.41% R* = 5.647% Total tax rate = 0.25 +.0441 = 29.41% When t > 29.41% invest in preferreds t < 29.41% invest in bonds

6 Università Bocconi, A.A: 2005-2006 6 Mec – Comparative public economics 6 Tax planning analysis Issue bonds buy preferreds 0.06 (1 –.2 t) – 0.08 (1 – t) > 0 if t > 29.41% Issue preferreds and buy bonds 0.08 (1 – t) – 0.06 >0 if t < 25%

7 Università Bocconi, A.A: 2005-2006 7 Mec – Comparative public economics 7 Tax planning analysis 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 0%10%20%30%40% Tax rate After-tax returni Issue preferreds Buy bonds Issue bonds Buy preferreds No tax arbitrage Hold idle cash in bonds

8 Università Bocconi, A.A: 2005-2006 8 Mec – Comparative public economics 8 Optimal strategies with no transaction costs

9 Università Bocconi, A.A: 2005-2006 9 Mec – Comparative public economics 9 Transaction costs Costs of bond issuance : 8.4% + 0.04%* $ millions Costs of preferred stock Issuance: 6.3% + 0.03%* $ millions

10 Università Bocconi, A.A: 2005-2006 10 Mec – Comparative public economics 10 Issue preferreds (6.3% +.03%P) buy bonds 8%(1 – t%)

11 Università Bocconi, A.A: 2005-2006 11 Mec – Comparative public economics 11 Issue bonds (8.4% +.04%B)(1-t) Buy preferreds 6%(1-.2t)

12 Università Bocconi, A.A: 2005-2006 12 Mec – Comparative public economics 12 Optimal strategies 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 0510152025303540455055 Securities issued Marginal tax rate Issue preferreds Buy bonds Issue bonds Buy preferred Idle cash invested in bonds Idle cash invested in preferred

13 Università Bocconi, A.A: 2005-2006 13 Mec – Comparative public economics 13 Corporate marginal tax rate Assumptions: tax loss carryforwards $20 millions In each of the following 3 years NIBIT Probability 60% : $15 milions Probability 40% :-$10 milions

14 Università Bocconi, A.A: 2005-2006 14 Mec – Comparative public economics 14 Uncertain NIBIT

15 Università Bocconi, A.A: 2005-2006 15 Mec – Comparative public economics 15 Marginal effective tax rate (METR) The present value of current plus deferred income taxes to be paid per dollar of additional taxable income s– future period in which the is eventually taxed on the extra dollar of income earned in year t r- firm’s after-tax discount rate

16 Università Bocconi, A.A: 2005-2006 16 Mec – Comparative public economics 16 Expected marginal tax rates

17 Università Bocconi, A.A: 2005-2006 17 Mec – Comparative public economics 17 Beginning of year 2 analysis

18 Università Bocconi, A.A: 2005-2006 18 Mec – Comparative public economics 18 Optimal strategies

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