Taxes and Financing Decisions Jonathan Lewellen & Katharina Lewellen
Overview Taxes and corporate decisions What are the tax effects of capital structure choices? How do taxes affect the cost of capital? How do taxes affect payout decisions? How do taxes affect firms’ real investment decisions? 2
Trade-off theory Firm value V U + tax shields V U + tax shields – distress costs Leverage 3
Trade-off theory Firm value V U + tax shields Debt vs. equity: (1 – τ d ) vs. (1 – τ c )(1 – τ e ) V U + tax shields – distress costs Leverage 4
Trade-off theory Firm value V U + tax shields Debt vs. equity: (1 – τ d ) vs. (1 – τ c )(1 – τ e ) V U + tax shields – distress costs Target capital structure Leverage 5
Main argument Internal equity is cheaper than external equity 6
Main argument Internal equity is cheaper than external equity Cash distributions trigger personal taxes Tax deferral benefit of retained earnings helps offset the tax disadvantage of equity 7
Main argument Internal equity is cheaper than external equity Cash distributions trigger personal taxes Tax deferral benefit of retained earnings helps offset the tax disadvantage of equity Our goal Quantify this effect Study the impact on capital structure, payout policy, and the cost of capital 8
Example Firm has $1 Distribute now Investors get (1 – τ e ), grows to (1 – τ e ) [1 + r (1 – τ i )] Distribute next year Grows to 1 + r (1 – τ c ), investors get (1 – τ e ) [1 + r (1 – τ c )] 9
Example Firm has $1 Distribute now Investors get (1 – τ e ), grows to (1 – τ e ) [1 + r (1 – τ i )] Distribute next year Grows to 1 + r (1 – τ c ), investors get (1 – τ e ) [1 + r (1 – τ c )] Retaining better if τ c < τ i Internal equity has tax benefits if τ c < τ i 10
Example Firm has $1 Distribute now Investors get (1 – τ e ), grows to (1 – τ e ) [1 + r (1 – τ i )] Distribute next year Grows to 1 + r (1 – τ c ), investors get (1 – τ e ) [1 + r (1 – τ c )] Retaining better if τ c < τ i Internal equity has tax benefits if τ c < τ i Trade-off: accelerate taxes vs. double taxation 11
Example This paper Clarify and generalize this idea (the example makes strong implicit assumptions) Miller (1977): (1 – τ c ) (1 – τ e ) > (1 – τ i )? Understand the implications for a firm’s capital structure, payout policy, and cost of capital 12
Overview Clarify the literature Capital structure Miller (1977), Hennessy and Whited (2004) Dividend taxes King (1974), Auerbach (1979), Poterba and Summers (1985) 13
Outline Simple model with two periods Discuss the literature Implications for corporate behavior Empirical estimates of the tax costs of equity 14
Model Study tax effects No agency conflicts, information asymmetries, or distress costs t = 0 t = 1 t = 2 Investment opportunity, Y Project pays Y + P 1 Liquidation Raise D 0 , S 0 Repay debt Equity distribution, δ 1 Cash: C 0 = D 0 + S 0 – Y Raise D 1 , S 1 Invest cash in riskless asset 15
Model Study tax effects No agency conflicts, information asymmetries, or distress costs t = 0 t = 1 t = 2 Investment opportunity, Y Project pays Y + P 1 Liquidation Raise D 0 , S 0 Repay debt Equity distribution, δ 1 Cash: C 0 = D 0 + S 0 – Y Raise D 1 , S 1 Invest cash in riskless asset 16
Assumptions Debt is short term Risk neutral investors, interest rate = r Project return P 1 > Y r [no bankruptcy] Taxes Corporate tax rate is τ c , personal tax rates are τ i , τ dv , τ cg Capital gains taxed on realization (trading at t = 1 exogenous) Liquidating dividends not taxed on portion that represents capital repayment 17
Assumptions Debt is short term Risk neutral investors, interest rate = r Project return P 1 > Y r [no bankruptcy] Taxes Corporate tax rate is τ c , personal tax rates are τ i , τ dv , τ cg Capital gains taxed on realization (trading at t = 1 exogenous) Liquidating dividends not taxed on portion that represents capital repayment 18
Assumptions Classic tax system Corporate profits, after interest, taxed at τ c Personal income taxed at τ i , τ dv , τ cg Imputation system Personal tax credit for corporate taxes already paid on dividends Effectively: τ dv = 1 – (1 – τ i ) / (1 – τ c ) 19
Assumptions Debt is short term Risk neutral investors, interest rate = r Project return P 1 > Y r [no bankruptcy] Taxes Corporate tax rate is τ c , personal tax rates are τ i , τ dv , τ cg Capital gains taxed on realization (trading at t = 1 exogenous) Liquidating dividends not taxed on portion that represents capital repayment 20
Model Exogenous trading t = 0 t = 1 t = 2 Investors: Trade α of their shares Realize gains of α (V 1 – S 0 ) Tax basis = (1 – α ) S 0 + α V 1 21
Model Taxes t = 0 t = 1 t = 2 No taxes Corporate tax Corporate tax Capital gains tax on a Personal tax on fraction of shares dividends / liquidating repurchase Personal tax on dividends / repurchases 22
Tax effects Debt financing New external equity Internal equity / retained earnings 23
Cashflows Firm’s cashflows Arrival to date 1: C 1 = Y + P 1 (1 – τ c ) + (C 0 – D 0 ) [1 + r (1 – τ c )] Exit from date 1: C 1 ′ = C 1 + D 1 + S 1 – δ 1 Arrival to date 2: C 2 = (C 1 ′ – D 1 ) [1 + r (1 – τ c )] 24
Cashflows Firm’s cashflows Arrival to date 1: C 1 = Y + P 1 (1 – τ c ) + ( C 0 – D 0 ) [1 + r (1 – τ c )] Exit from date 1: C 1 ′ = C 1 + D 1 + S 1 – δ 1 Arrival to date 2: C 2 = ( C 1 ′ – D 1 ) [1 + r (1 – τ c )] 25
Transactions at date 1 Proposition Issuing debt to hold as cash (i.e., to invest in the riskfree asset) has no effect on value, regardless of tax rates 26
Transactions at date 1 Proposition Issuing debt to hold as cash (i.e., to invest in the riskfree asset) has no effect on value, regardless of tax rates Implications Debt does not create value, via interest tax shields; only important if it changes equity Using cash to pay down debt doesn’t affect value either In transactions with equityholders, it doesn’t matter where cash comes from or goes to 27
Transactions at date 1 Proposition Issuing debt to hold as cash (i.e., to invest in the riskfree asset) has no effect on value, regardless of tax rates Implications Debt does not create value, via interest tax shields; only important if it changes equity Using cash to pay down debt doesn’t affect value either In transactions with equityholders, it doesn’t matter where cash comes from or goes to 28
Equity financing at date 1 External equity Raise S 1 at date 1 Shareholders’ CF 2 = π 2 + S 1 [1 + r (1 – τ c )(1 – τ e )] τ e is either τ cg or τ dv 29
Equity financing at date 1 External equity Raise S 1 at date 1 Shareholders’ CF 2 = π 2 + S 1 [1 + r (1 – τ c )(1 – τ e )] τ e is either τ cg or τ dv NPV Invest S 1 = $1 in the firm: 1 + r (1 – τ c )(1 – τ e ) Invest $1 outside the firm: 1 + r (1 – τ i ) 30
Equity financing at date 1 Proposition 2 (Miller)* If the firm uses repurchases, the tax benefit of external equity is: r [(1 – τ c )(1 – τ cg ) – (1 – τ i )] PV(S 1 ) = S 1 + − τ 1 r ( 1 ) i If the firm uses dividends, the tax benefit of external equity is: r [(1 – τ c )(1 – τ dv ) – (1 – τ i )] PV(S 1 ) = S 1 + − τ 1 r ( 1 ) i 31
Equity financing at date 1 Internal equity: retained earnings vs. repurchases 32
Equity financing at date 1 Internal equity: retained earnings vs. repurchases Distribute all cash at date 1 CF 1 = C 1 – τ cg (C 1 – S 0 ) t = 1: 33
Equity financing at date 1 Internal equity: retained earnings vs. repurchases Distribute all cash at date 1 CF 1 = C 1 – τ cg (C 1 – S 0 ) t = 1: Fully retain, distribute at date 2 CF 1 = – α τ cg (V 1 – S 0 ) t = 1: CF 2 = C 2 – τ cg (C 2 – TB 1 ) t = 2: [V 1 = PV(CF 2 )] 34
Equity financing at date 1 Proposition 3 The tax benefit of internal equity at date 1, or the PV of retained cash vis-à-vis a share repurchase, is − τ r ( 1 ) cg [ (1 – τ c )(1 – βτ cg ) – (1 – τ i ) ] PV(RE 1 ) = RE 1 + − τ − βτ 1 r ( 1 ) i cg where β = TB 1 / V 1 , the tax basis relative to current price when the firm doesn’t repurchase 35
Equity financing at date 1 Proposition 3 The tax benefit of internal equity at date 1, or the PV of retained cash vis-à-vis a share repurchase, is − τ r ( 1 ) cg [ (1 – τ c )(1 – βτ cg ) – (1 – τ i ) ] PV(RE 1 ) = RE 1 + − τ − βτ 1 r ( 1 ) i cg where β = TB 1 / V 1 , the tax basis relative to current price when the firm doesn’t repurchase β determines how much tax is triggered by repurchase at t = 1 36
Equity financing at date 1 Case 1: β = 0 [ α = 0, S 0 = 0] 37
Equity financing at date 1 Case 1: β = 0 [ α = 0, S 0 = 0] Internal equity has tax benefit (better than debt) if τ c < τ i − τ r ( 1 ) cg [ (1 – τ c ) – (1 – τ i ) ] PV(RE 1 ) = RE 1 + − τ 1 r ( 1 ) i 38
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