Capital Budgeting: a Tax Shields Mirage?

Transcription

1 Theoreical ad Applied Ecoomics Volume XVIII (211), No. 3(556), pp Capial Budgeig: a Tax Shields Mirage? Vicor DRAGOTĂ Buchares Academy of Ecoomic Sudies vicor.dragoa@fi.ase.ro Lucia ŢÂŢU Buchares Academy of Ecoomic Sudies lucia.au@fi.ase.ro Absrac. The maisream i Fiace sudies recogizes he impac of ax shields o capial budgeig. This sudy offers some evideces regardig a bias i direc ivesme projecs valuaio i he case of akig io accou of he allowace of recovery of he losses recorded i he pas fiacial exercises from fuure profis as log as he classical idicaors (e.g., Ne Prese Value) are used. Also, his ax regime seems o favour he adopio of less-performer projecs by lessperformer compaies, as log as hese projecs should be oherwise rejeced by a performer compay. Keywords: capial budgeig; ax shields; recovery of losses; e prese value; cash flows. JEL Code: G31. REL Code: 11D.

2 32 Vicor Dragoă, Lucia Ţâţu 1. Iroducio A a macroecoomic level, axes are ackowledged by may expers as a ool ha ca be used i order o have a ifluece o ecoomy or eve o sociey (Văcărel e al., 27, Obreja Braşoveau, Braşoveau, 28). However, o always his isrume achieves his goal (Dragoă, Dragoă, Ţâţu, Ţâţu, 29). A his mome, may couries have adoped he priciple of allowig he recovery of losses from he profis supposed o be recorded i he followig fiacial exercises. For example, i he Europea Uio, he allowace of recovery of ax loss is sipulaed i saes such as: Ausria, Belgium, Frace, Filad, Lihuaia, Luxembourg, Neherlads, Romaia, Spai, Swede, Uied Kigdom ( The mai explaaio for his regulaio is o ecourage he ecoomic growh. A suppor for compaies ha record losses ca be acceped as log as hese compaies will deermie ecoomic growh i he fuure. The aalysis of he impac of ax regulaios o he corporae fiacial policies is a permae presece i fiacial heory. However, emphasis was placed o he ax impac o fiacig ad divided policies, proof hereof beig made by he log lis of aricles published i his field, iiiaed by Modigliai ad Miller (1963) regardig fiacial srucure, ad Miller ad Modigliai (1961) o he subjec of divided policy. Cocerig capial budgeig, mos fiace sudies ake io accou he impac of axes o he performace of ivesme projecs or, more precisely, he impac of ax shields o he cash flows geeraed by he ivesmes projec. For example, i is recogized i his coex he impac of ax shields resulig from deb, which ca improve he performace of a ivesme projec. Maily, he basic idea behid he cocep of ax shields is ha some projecs fiaced by 1% equiy mus be rejeced (e prese value (1), NPV < ), while he same projecs, bu fiaced by a mix of equiy ad deb, due o ax shields, ca be adoped (NPV > ) (Modigliai, Miller 1963, Ross, Weserfield, Jaffe, 1999). I fac, his eire judgeme is based o he idea o correc he cash flows produced by he ivesme projec wih ax shields due o idebedess. Similarly, i ca be saed ha a compay ca beefi from ax shields resulig from recovery of losses recorded i he previous fiacial years. By allowig he deducio of losses from axable profi recorded by compaies, he cash flows geeraed by hese compaies will be also affeced. Regardig he

3 Capial Budgeig: a Tax Shields Mirage? 33 aalysed ivesme projec, his ax regulaio will affec he cash flows ad, also, he discou rae. Somehow, his issue will violae oe geerally acceped priciple i ivesme projecs valuaio, respecively o assess he projec i is idividualiy, i.e. o ake io accou oly is idepede performace, ad o he geeral performace of he compay ha aalyse he projec (Ross, Weserfield, Jaffe, 1999). However, he compaies ha have recorded fiacial losses i he previous years will be able o icrease he level of heir cash flows by addig he allowed recovery of fiacial loss. We will emphasize ha his regulaio promoes he adopio of relaively uproducive projecs by he compaies ha beefi from his ax faciliy. Moreover, some direc ivesme projecs ha oherwise would be rejeced (if hey were aalyzed idepedely, by a compay ha does o beefi of his faciliy) may become aracive for hese o-profiable compaies. The mai purpose of his sudy is o highligh he limis of he classical idicaors of ivesme projecs valuaio for he compaies ha have he righ o recover ax losses. Pracically, hese idicaors are uable o provide accurae iformaio ecessary for akig decisios based o he valuaio of direc ivesme projecs, ad have o be aalysed cauiously. The paper may be useful o decisio makers ivolved i he aalysis of ivesme projecs, bu also ca provide some ideas o ax regulaors. The remaiig par of he sudy is srucured as follows. I Secio 2 i will be preseed he case of he valuaio of ivesme projecs i he absece ad i he presece of he ierferece give by he possibiliy of recovery of ax losses recorded i he previous years. Secio 3 cocludes he sudy. 2. Valuaio of ivesme projecs as log as he recovery of losses from previous years is allowed Geeral pracice i corporae fiace is o ake accou of fiscal issues i he esimaio of he cash flows geeraed by he ivesme projec. The forecas of icome ax will be doe based o he (expeced) ax rae ad o forecased axable profi. Regardig he deermiaio of icome ax for a egaive axable resul (loss), wo possibiliies are acceped: a) o apply he ax rae o loss, which will produce a egaive ax or a curre ax shields. I his approach, i is assumed ha he ivesme projec is par of he compay's ivesme porfolio, so he loss will deermie a lower axable profi for he compay a he prese mome. Thus, he compay will have o pay a lower

4 34 Vicor Dragoă, Lucia Ţâţu icome ax comparaive o he case i which he projec would o be adoped; b) o cosider he zero icome ax, bu o carryover he acual loss i he ex years, so ha he fuure ax profis will be lower his is equivale o a fuure ax shields. This opio assumes ha he ivesme projec is cosidered idepede of he compay's aciviy or ha he compay has a ivesme porfolio cosisig oly i his projec (Dragoă, Ciobau, Obreja, Dragoă, 23, vol. II, p. 49). I oher words, he lieraure sresses he possibiliy of recovery of losses, implyig he reducio i he ax paymes i subseque fiacial years, bu also emphasizes he valuaio of ivesme projecs i is idividualiy. Ayway, a fiacial idicaor has o express somehig for his user. For isace, NPV has o eloquely explai if a projec should be acceped or o, i accordace wih he priciple of maximizaio of he shareholders wealh, which is sipulaed i he mai sream of fiacial lieraure (Ross, Weserfield, Jaffe, 1999). Alhough he saed purpose of corporae fiace is o maximize shareholder wealh, which would raslae o he exclusive adopio of projecs ha deermie a maximum (posiive, o he limi) NPV (Ross, Weserfield, Jaffe, 1999), maagers ca be more iclied for holdig he fiacial resources, as a measure of discreio i decisio makig, presige (achieved i coemporary orgaizaios hrough access o he highes volume of moey), ec. This pheomeo was highlighed eve i classical papers (Cyer, March, 1963, Jese, Mecklig, 1976, Jese, 1986). Moreover, i a more rece sudy, Loderer, Roh Waelchli ad Joerg (21) show ha mos maagers of compaies i he world do o meio he ieres for shareholders i heir saemes o compay goals. Regardig he ivesme policy of compaies, his may be raslaed io a highes allocaio of fuds for fiacig ivesme projecs, eve hese projec are o so performaive. Oe example, exremely simplified, will express he pheomeo. Le s cosider a projec ha geeraes a umber of aual cash flows (CF ) for a period of years (for simpliciy, we assume a zero residual value). By hypohesis, i he eire sudy, we assume ha he projecs are fiaced eirely from equiy ad he rae of reur required by ivesors is k. Projec cos is I. Ne prese value of he projec is: NPV = I CF = 1 ( 1 k) (1)

5 Capial Budgeig: a Tax Shields Mirage? 35 The projec is accepable if ad oly if NPV >, respecively: = 1 1 CF > ( k) I (2) I may be oiced ha he ivesme projec valuaio has o be doe idepedely of he compay ha aalyze i, give ha he oly key variables are he cash flows geeraed by he projec (differeces bewee cash iflows ad cash ouflows arisig from he projec), he rae of reur required by ivesors ad he projec cos, variables deermied by he expeced codiios relaed o he projec. Amog hese deermias i ca be meioed he payme of he icome ax, calculaed also o he basis of projec performace. I ca be sressed ha his level of icome ax will o be affeced by he overall performace of he compay, bu oly relaes o he projec performace. If we ake io accou he possibiliy of recovery of ax losses previously recorded by he compay (or eve recorded simulaeously wih he ivesme projec), a arificial icrease i cash flows o he compay level ca be iduced. I is obvious ha his pheomeo creaes a relaively mirage, ivesme projecs performace appearig o be less aracive for performig compaies ha i he case of o-performig compaies. I addiio, a sysem based o he growh of cerai expediures ca simulae boh he lack of performace i carryig coss (such a ujusified icrease of hem), ad a aleraio of performace idicaors of ivesme projecs, especially if oe akes io accou he agecy problems prese a compay level. Here, i has o be cosidered oe impora disicio bewee ax shields due o idebedess ad he oes due o he allowace for losses recovery. I he firs case, he fiacial srucure for fiacig he projec is deermiig he ax shields. Here, he priciple of direc ivesme projec valuaio i is idividualiy is applied. However, i he secod case, a impac of losses from pas projecs (wih o coecio wih he aalysed projec) ca ierfere i he projec valuaio, so his priciple is o applied aymore. To exemplify his pheomeo, we sar from a simple umerical case, bu ha ca be easy geeralized. Le cosider wo compaies, A ad B, of equal marke value, V, ideical i all respecs. For simpliciy, we assume ha hese wo compaies are o-levered for he eire period of aalysis ad ha all heir aciviy is quaified as a sigle ivesme projec. As such, we assume ha each of hese wo compaies adoped oe sigle ivesme projec. The compay A has adoped a projec ha has produced

6 36 Vicor Dragoă, Lucia Ţâţu profi, while compay B has adoped a projec ha has geeraed ax losses. The life ime of hese wo projecs was ideical, ad boh projecs are currely compleig. Alhough marke values of he wo compaies were origially ideical, currely hey are differe. For simpliciy, we assume ha he life ime of hese wo projecs was oe year. This simplificaio does o chage he mai coclusios, while wha havig effec is he exisece/absece of ax shields. I ormal ecoomic codiios, we have o impose he codiio ha he ax losses o do o exceed he e asses of he compay, so as o o rigger bakrupcy proceedigs (2). Currely, compay A ca o beefi from he righ o recover losses. Also, compay B has he righ o recover a ax loss of 5 moeary uis (hereafer, m.u.). Each compay aalyzes he adopio of a ivesme projec, wih equal cos ad he same levels for resulig expeced cash flows. Agai, for reasos of simpliciy, we assume ha he ivesme projec life ime is limied o oe year, ad he cash flow from he firs year is icludig he residual value (3). The ivesme projec requires a iiial ivesme of 6 m.u., ad he expeced cash flow is 65 m.u. We cosider a discou rae of projec ivesme of 1%, boh for compay A ad for compay B (4). For he compay A, he NPV is: A CF 65 NPV = I = m.u. 1.1 = (3) = 1 ( 1 k) For he compay B, if he recovery loss is o cosidered, NPV will be equal, respecively: B CF 65 NPV = I = m.u. 1.1 = (4) = 1 ( 1 k) The aalysis of he ivesme projec shows a egaive NPV for boh compaies. Accordigly, uder he priciples of assessme of ivesme projecs, he projec should be rejeced by boh compaies. The purpose of fiacial idicaors is o provide useful iformaio for maageme decisios, i his case regardig adopig or rejecig a ivesme projec. I his case, because of he ierferece iduced by allowig recovery of losses, NPV is o recommeded. We sress ha his does o mea

7 Capial Budgeig: a Tax Shields Mirage? 37 challegig he classical idicaors of capial budgeig for ormal circumsaces of busiess aciviies, bu oly i hese resricive codiios. I he case of compay B, due o he ifluece of previous aciviy recovery loss, we ca calculae a idicaor (oed here NPV*): NPV B * = I CF TS = ( ) 1 1 k δ (5) I his equaio, he cash flow from equaio (4) was correced i order o ake io accou he ax shield, TS. Also, he usual discou rae (k) has o be correced i order o ake io accou he impac of ax shields. We preferred a correcio facor, δ, wih δ (, 1], where δ = 1 reflecs a zero ax shield, ad δ = reflecs a 1% icome ax rae. By his correcio, i is ake io accou he coherece bewee he cash flow (his oe has o ake io accou he ax shield) ad he discou rae (his oe has o ake io accou his ax shield, oo). There is a logical relaioship bewee he cash flows ad he discou raes: as log as he compay ca beefi from he righ o reduce he axable icome, he cos of capial will decrease. We preferred his formalizaio isead of classical (1 - τ), where τ is he icome ax rae, because loss ca be recovered by profis (posiive icomes) a differe fuure momes, so he relaioship bewee ax rae ad cash flows is o sable. For he umerical example, supposig δ =.9, he correced NPV is (5), (6) : NPV B CF TS * = I ( 1 k δ ) % = = = m.u. (6) As log as compay B beefis from a cash flow poeial ha ca be maerialized oly i he case of he adopio of he projec (respecively, he ax shield, TS ), i is mos likely o adop he ivesme decisio. I ca be oiced also ha, i his case, classical NPV does o offer he correc iformaio for he maageme. I should also be oed ha he adopio of he ivesme projec is recommeded for his compay, because oherwise i would o be able o recover he losses from he previous years. Seemigly, i ca be argued ha his reducio i axable icome would be egligible if he muli-periodic case will be aalysed. I fac, his is o so impora as log as we compare wo compaies, of which oly oe beefis by he righ o recovery losses. I oher words, le suppose a ivesor aalyses a

8 38 Vicor Dragoă, Lucia Ţâţu ivesme projec i wo scearios: (i) esablish a ew compay; (ii) buy a old compay, which has he righ o recover losses. I his case, i seems o be obvious ha he secod choice is beer. 3. Coclusios The recovery of losses creaes a relaively mirage. Usig he classical e prese value crierio, he performaive compaies will rejec some projec (less performaive), bu some less performaive compaies could accep he same projecs! Furhermore, his ax regulaio ecourages he adopio of o-performig projecs by o-performig busiesses, which would be rejeced if he busiess would be performer. For he fiacial aalyss, he effecs of he allowace for recovery of losses have o be ake io accou. These ca chage he ormal verdic regardig recommedaio for adopio or rejecig a ivesme projec based o NPV crierio. Moreover, he classical priciple of he valuaio of he ivesme projec idepedely by he adopig compay has o be used cauiously. Ackowledgemes This paper is a resul of he projec Direcios for Improvig he Sysem of Idicaors Used i Direc Ivesme Projecs Valuaio, Program IDEI, CNCSIS, Romaia, Code 182/28. The auhors wish o hak o he 45 h Europea Workig Group o Fiacial Modellig Chaia Meeig (29), o he Ieraioal Coferece Fiacial Treds i he Global Ecoomy (orgaized by Babeş-Bolyai Uiversiy of Cluj-Napoca, 29) ad o he INVESTEVAL-29 Workshop (Buchares Academy of Ecoomic Sudies) paricipas. We have beefied by he very useful commes provided by Delia Caaramă, Peer L. Jeergre, Joao Oliveira Soares, El Thalassios, ad Alexadru Todea. The remaiig errors are ours.

9 Capial Budgeig: a Tax Shields Mirage? 39 Noes (1) (2) (3) (4) (5) Throughou he eire sudy, he refereces o he capial budgeig decisios are based o he e prese value (NPV) crierio. Of course, all hese cosideraios ca be easy geeralized o ay oher idicaor used i capial budgeig aalysis ieral rae of reur, modified ieral rae of reur, payback period, ec. Eve his codiio is quesioable i cerai siuaios. For example, i Romaia, some compaies have recorded levels of egaive equiy, bu are o i bakrupcy proceedigs. Normally, his assumpio does o chage he coclusios of he sudy. Oe ca assume ha he projecs will be sold o he marke a prices reflecig marke expecaios regardig he fuure performace of he projec. As log as he marke where his rasacio is carried ou eds owards efficiecy, i will o appear sigifica problems. Moreover, uder ormal codiios, eve if he marke is o efficie, he bes predicio made a his ime for he expeced resale price of he projec over oe year is is irisic value. For Romaia capial marke, see ess of iformaioal efficiecy i Dragoă ad Mirică (24), Pele ad Voieagu (28), ad Dragoă, Soia, Pele, Mirică ad Besafa (29). This assumpio ca be cosidered quesioable, eve he projecs are ideical. I ca be cosidered a differe discou rae for hese wo projecs. This differece ca be explaied by he higher risk expeced by he ivesors i Compay B. Ideed, he ivesors i Compay B ca aicipae a higher operaioal risk, due o he lower pas performace of his compay. Ayway, his assumpio does o chage he logic of he demosraio as log as he umerical resul sill holds eve if here are used differe discou raes (e.g., 1% for A ad 2% for B). I he case of a higher discou rae (le i be 2%) for he compay B, if he recovery loss is o cosidered, NPV is: NPV B ( 1 k) 65 = = = 1 = I CF m.u. As observed, NPV for compay B may be lower, plausible as his seems o prese a greaer risk from he ivesors poi of view. For he umerical example, supposig δ =.9, he correced NPV is: B CF TS NPV * = I ( 1 k δ ) % = = = m.u. (6) To highligh he impac of he ax shield give by he allowace of recoverable loss, we have cosidered a icome ax rae of 16%, applied i some couries (e.g., i Hugary ad Romaia).

10 4 Vicor Dragoă, Lucia Ţâţu Refereces Cyer, R.M., March, J.G. (1963). A Behavioral Theory of he Firm, Preice-Hall, Eglewood Cliffs, New Jersey Dragoă, M., Dragoă, V., Ţâţu, L., Ţâţu, D., Icome Taxaio Regulaio Ad Compaies Behaviour: Is The Romaia Compaies Divided Policy Iflueced by he Chages i Icome Taxaio?, Joural for Ecoomic Forecasig, vol. 6(1), 29, pp Dragoă, V., Ciobau, A., Obreja, L., Dragoă, M. (23). Maageme fiaciar, Ediura Ecoomică, Bucureşi Dragoă, V., Mirică, E., Emerge capial marke s efficiecy: The case of Romaia, Europea Joural of Operaioal Research, 155, 24, pp Dragoă, V., Soia, A., Pele, D.T., Mirică, E., Besafa, M., The Developme of he Romaia Capial Marke: Evideces o Iformaio Efficiecy, Joural of Ecoomic Forecasig, vol. 1 (2), 29, pp Jese, M.C., Agecy Coss of Free Cash Flows, Corporae Fiace ad Takeovers, America Ecoomic Review, 76 (May) 1986, pp Jese, M.C., Mecklig, W.H., Theory of he Firm: Maagerial Behavior, Agecy Coss ad Owership Srucure, Joural of Fiacial Ecoomics, 3, 1976, pp Loderer, C.F., Roh, L., Waelchli, U., Joerg, P., Shareholder Value: Priciples, Declaraios, ad Acios, Fiacial Maageme, 39, 21, pp Miller, M., Modigliai, F., Divided Policy, Growh, ad he Valuaio of Shares, Joural of Busiess, No. 4, 1961, pp Modigliai, F., Miller, M.H., Corporae Icome Taxes ad he Cos of he Capial: a Correcio, America Ecoomic Review, 1963, (3), 1963, pp Obreja Braşoveau, L., Braşoveau, I., The Correlaio bewee Fiscal Policy ad Ecoomic Growh, Theoreical ad Applied Ecoomics, vol. XV, o. 7(524), 28, pp Pele, D.T., Voieagu, V., Tesig Marke Efficiecy via Decomposiio of Sock Reur. Applicaio o Romaia Capial Marke, Joural of Ecoomic Forecasig, o. 3, 28, pp Ross, S., Weserfield, R., Jaffe, J. (1999). Corporae Fiace, Irwi/McGraw-Hill Văcărel, I. (coordoaor), Aghelache, G., Bercea, F., Bisriceau, G.D., Bodar, M., Moşeau, T., Georgescu, F. (27). Fiaţe publice, ediţia a şasea, Ediura Didacică şi Pedagogică, Bucureşi The Taxes i Europe Daabase