16_Oheads

16_Oheads - Lecture Notes 16 Limits to the Use of Debt...

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1 Lecture Notes 16 Limits to the Use of Debt Personal taxation of corporate income • Prior to the recent tax reforms, dividends, like interest, were taxed as ordinary income. • Under the new reforms, dividends are taxed at a preferential rate. In addition, however, capital gains are taxed: i. at preferential rates and ii. only upon realization. • Taxing capital gains only after realization amounts to delaying the tax bill without charging interest. • Income used to: i. repurchase shares, or ii. retained to invest in positive NPV projects will lead to capital gains on shares equal to the income that could otherwise be paid as dividends without affecting share prices.
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2 • In a non-indexed tax system, however, inflation raises the effec- tive tax rate on capital gains by incorrectly measuring nominal gains as real income. • In contrast, while nominal interest receipts are taxed, nominal payments are deducted by corporations so the net effect of infla- tion on debt payments is smaller than its effects on capital gains. • Summary statement: While the corporate tax favors debt, the personal tax, in the absence of high inflation and a non-indexed tax system, favors equity. Gains from leverage with both corporate and personal taxes • Let the effective personal tax on shareholder income be T S while T B is the personal tax on interest. We assume that T S < T B . • After-tax shareholder income is (EBIT– r B B )(1– T c )(1– T S ); bondholders get r B B (1– T B ). • The total after-tax cash flow to all investors will therefore be
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3 (1) • EBIT(1– T c )(1– T S ), the after-tax cash flow of an unlevered firm, has value V U . The market value of r B B (1– T B ) must be B . Hence (2) • If T B = T S then (2) becomes V L = V U + T c B . However, T S < T B and thus personal taxes offset the tax benefits of debt. Neverthe- less, it is likely that (1– T B ) > (1– T c )(1– T S ). Figure 1: Firm value as a function of leverage EBIT r B B () 1 T c 1 T S r B B 1 T B + EBIT 1 T c 1 T S r B B 1 T B 1 1 T c 1 T S 1 T B ---------------------------------------- + = V L V U B 1 1 T c 1 T S 1 T B + = Value of Firm ( V ) Debt ( B ) V U V L = V U + T c B V L V U 1 1 T c 1 T S 1 T B B + = when (1– T B ) > (1– T c )(1– T S )
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4 Non-tax effects of leverage • Payments on debt are a legal obligation, but may be impossible if the firm has insufficient revenue. • In practice, debt and equity are both contingent claims and both can have risk associated with them. 1. Costs of financial distress • With bankruptcy, V L = V U + PV(tax saving) – PV(distress costs) Direct legal, administrative, accounting costs of bankruptcy are about 3% of liquidated firm value. • There are also many indirect costs of approaching bankruptcy: i. Adverse effects on customers, suppliers and employees.
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This note was uploaded on 12/20/2011 for the course ECON 448 taught by Professor Bejan during the Spring '06 term at Rice.

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16_Oheads - Lecture Notes 16 Limits to the Use of Debt...

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