Lecture 10. Capital structure 2 Taxes

Transcription

1 Lecture 10 Capital structure 2 Taxes

2 15.1 The Interest Tax Deduction Consider Safeway, Inc. which had earnings before interest and taxes of approximately $1.25 billion in 2005, and interest expenses of about $400 million. Safeway s marginal corporate tax rate was 35%. As shown on the next slide, Safeway s net income in 2005 was lower with leverage than it would have been without leverage. Copyright 2007 Pearson Addison-Wesley. All rights reserved. 15-2

3 15.1 The Interest Tax Deduction Safeway s debt obligations reduced the value of its equity. But the total amount available to all investors was higher with leverage. Without leverage, Safeway was able to pay out $812 million in total to its investors. With leverage, Safeway was able to pay out $952 million in total to its investors. Where does the additional $140 million come from? Copyright 2007 Pearson Addison-Wesley. All rights reserved. 15-3

4 15.1 The Interest Tax Deduction The reduction in taxes paid due to the tax deductibility of interest Interest Tax Shield Corporate Tax Rate Interest Payments In Safeway s case, the gain is equal to the reduction in taxes with leverage: $438 million $298 million = $140 million. The interest payments provided a tax savings of 35% $400 million = $140 million. Copyright 2007 Pearson Addison-Wesley. All rights reserved. 15-4

5 Example 15.1 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 15-5

6 Example 15.1 (cont'd) Copyright 2007 Pearson Addison-Wesley. All rights reserved. 15-6

7 15.2 Valuing the Interest Tax Shield When a firm uses debt, the interest tax shield provides a corporate tax benefit each year. This benefit is the computed as the present value of the stream of future interest tax shields the firm will receive. The cash flows a levered firm pays to investors will be higher than they would be without leverage by the amount of the interest tax Cash Flows to Investors Cash Flows to Investors with Leverage without Leverage (Interest Tax Shield) Copyright 2007 Pearson Addison-Wesley. All rights reserved. 15-7

8 MM Proposition I with Taxes The Interest Tax Shield and Firm Value 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. L U V V PV (Interest Tax Shield) Typically, the level of future interest payments is uncertain due to changes in the marginal tax rate, the amount of debt outstanding, the interest rate on that debt, and the risk of the firm. For simplicity, we will consider the special case in which the above variables are kept constant. Copyright 2007 Pearson Addison-Wesley. All rights reserved. 15-8

9 The Interest Tax Shield with Permanent Debt (cont'd) 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. PV (Interest Tax Shield) c Interest r f c ( r D) r f f c D If the debt is fairly priced, no arbitrage implies that its market value must equal the present value of the future interest payments. Market Value of Debt D PV (Future Interest Payments) Copyright 2007 Pearson Addison-Wesley. All rights reserved. 15-9

10 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 E D rwacc re rd (1 c) E D E D r E wacc r D D E rd rd c E D E D E D Pretax WACC Reduction Due to Interest Tax Shield Copyright 2007 Pearson Addison-Wesley. All rights reserved

11 Figure 15.2 The WACC with and without Corporate Taxes Copyright 2007 Pearson Addison-Wesley. All rights reserved

12 The Interest Tax Shield with a Target Debt-Equity Ratio When a firm adjusts its leverage to maintain a target debt-equity ratio, we can compute its value with leverage, V L, by discounting its free cash flow using the weighted average cost of capital. The value of the interest tax shield can be found by comparing the value of the levered firm, V L, to the unlevered value, V U, of the free cash flow discounted at the firm s unlevered cost of capital, the pretax WACC. Copyright 2007 Pearson Addison-Wesley. All rights reserved

13 Example 15.3 (cont'd) Copyright 2007 Pearson Addison-Wesley. All rights reserved

14 15.3 Recapitalizing to Capture the Tax Shield 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. 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 Copyright 2007 Pearson Addison-Wesley. All rights reserved

15 The Tax Benefit 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 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. Copyright 2007 Pearson Addison-Wesley. All rights reserved

16 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 million shares outstanding. 20 million 6.67 million = million The total value of equity is $235 million; therefore the new share price is $17.625/share. $235 million million shares = $ Shareholders that keep their shares earn a capital gain of $2.625 per share. $ $15 = $2.625 The total gain to shareholders is $35 million. $2.625/share 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? Copyright 2007 Pearson Addison-Wesley. All rights reserved

17 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 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 Copyright 2007 Pearson Addison-Wesley. All rights reserved

18 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. Copyright 2007 Pearson Addison-Wesley. All rights reserved

19 15.4 Personal Taxes (cont'd) The cash flows to investors are typically taxed twice. Once at the corporate level and then investors are taxed 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. 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. 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. Copyright 2007 Pearson Addison-Wesley. All rights reserved

20 Figure 15.3 After-Tax Investor Cash Flows Resulting from $1 in EBIT Copyright 2007 Pearson Addison-Wesley. All rights reserved

21 Including Personal Taxes in the Interest Tax Shield In general, every $1 received after taxes by debt holders from interest payments costs equity holders $(1 *) on an after-tax basis, where: Effective Tax Advantage of Debt (1 i ) (1 c ) (1 e ) (1 c ) (1 e ) 1 (1 ) (1 ) i 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. i Copyright 2007 Pearson Addison-Wesley. All rights reserved

22 Alternative Example 15.5 Problem Given the following tax rates: Year Corporate Tax Rate Average Personal Tax Rate on Equity Income Average Personal Tax Rate on Interest Income % 35% 50% % 34% 28% % 15% 35% What is the effective tax advantage of debt for each of the years listed? Copyright 2007 Pearson Addison-Wesley. All rights reserved

23 Alternative Example 15.5 Solution (1 c ) (1 e ) 1 (1 ) (1.46 ) (1.35) (1.50 ) (1.35) (1.34 ) (1.28 ) i 29.8% 40.4% (1.35 ) (1.15 ) % (1.35 ) Copyright 2007 Pearson Addison-Wesley. All rights reserved

24 Valuing the Interest Tax Shield with Personal Taxes With personal taxes and permanent debt, the value of the firm with leverage becomes If * is less than c, the benefit of leverage is reduced in the presence of personal taxes. The bottom line: L U V V D Calculating the effective tax advantage of debt accurately is extremely difficult. A firm must consider the tax bracket of its typical debt holders, and the tax bracket and holding period of its typical equity holders. The tax advantage of debt will vary across firms and from investor to investor. Copyright 2007 Pearson Addison-Wesley. All rights reserved

25 15.5 Optimal Capital Structure with Do Firms Prefer Debt? Taxes 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. 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%. Copyright 2007 Pearson Addison-Wesley. All rights reserved

26 Figure 15.5 Net External Financing and Capital Expenditures by U.S. Corporations, Copyright 2007 Pearson Addison-Wesley. All rights reserved

27 Figure 15.7 Debt-to- Value Ratio [D / (E + D)] for Select Industries 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.

28 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. 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. Copyright 2007 Pearson Addison-Wesley. All rights reserved

29 The Low Leverage Puzzle 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 *. 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. 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. Copyright 2007 Pearson Addison-Wesley. All rights reserved

30 Table 15.5 Copyright 2007 Pearson Addison-Wesley. All rights reserved