LECTURE16

LECTURE16 - Lecture 16 Lecture Limits to the Use of Debt...

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Lecture 16 Lecture 16 Limits to the Use of Debt Limits to the Use of Debt
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Personal Taxation of Corporate Income While the corporate tax favors debt, the personal tax favors equity. Dividends, like interest, are taxed as ordinary income, but capital gains are taxed at preferential rates and only upon realization. Income used to repurchase shares, or retained to invest in positive NPV projects, will lead to capital gains on shares. Taxing capital gains only after realization amounts to delaying the tax bill without charging interest. However, inflation raises the effective tax rate on capital gains by incorrectly measuring nominal gains as real income. Capital gains equal the income that could otherwise be paid as dividends while leaving share prices unchanged. While nominal interest receipts are taxed, the nominal interest payments are deducted by corporation. Hence the net effect of inflation is smaller.
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Gains from Leverage with both Corporate and Personal Taxes Let be effective personal tax rate on shareholders income be personal tax on shareholders income B T S T Bondholders Shareholders ( 29 ( 29 ( 29 S C B T 1- T 1- B r - EBIT ( 29 B B T 1 B r - After tax income Total after tax cash flow to all investors ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 - - - - - + - - = - + - - B S C B B S C B B S C B T 1 T 1 T 1 1 T 1 B r T 1 T 1 EBIT T 1 B r T 1 T 1 B r - EBIT (after-tax cash flow of an unlevered firm) has value The market value of must be B U V ( 29 ( 29 ( 29 S C B T 1 T 1 B r - EBIT - - ( 29 B B T 1 B r -
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Gains from leverage with both Corporate and personal Taxes (continued) ( 29 ( 29 ( 29 - - - - + = B S C U L T 1 T 1 T 1 1 B V V Then we have the following expression for the value of the levered firm. Here, personal tax has no effect. T T if BT V V B S C U L = + = Personal tax offset benefits of debt. T T if BT V V B S C U L < + < Figure 1: Firm value as a function of leverage
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Non-tax effects of leverage Payments on debt are a legal obligation, but may be impossible to be paid. Debt and equity are both contingent claims and can both have risk. Cost of financial distress Incentive to take large risks Incentive to under-invest Non-financial benefits of debt Issues Figure 2: Payoffs to investers as a function of firm value
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1. Cost of financial distress Direct legal, administrative and accounting costs of bankruptcy are about 3% of liquidated firm value. There are many indirect costs of approaching bankruptcy
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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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LECTURE16 - Lecture 16 Lecture Limits to the Use of Debt...

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