Capital Structure

Personal Tax

References: RWJ Chapter 16

 Personal Taxes

• Investors care about their cash flow after personal taxes.

• In the US, at the personal level

– qualified dividends and capital gains are taxed at the same rate,
max of 20%
– interest income are taxed at same rate as ordinary income, can
be as high as 37%
– tax on interest income may be higher than tax on equity income

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 Personal Taxes

• At corporate level:
– Tax advantage of debt

• At personal investor level:

– Debt income may be taxed at a higher personal rate than
equity income
– Personal tax disadvantage of debt offsets the corporate tax
advantage of debt

• → Thus, we need to look at the net tax benefit of debt.

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The derivation is straightforward:
Stockholders in a levered firm receive
( EBIT − rB B )(1 − TC )(1 − TS )

Bondholder s receive
rB B (1 − TB )

Thus the total cash flow to all stakeholders is

( EBIT − rB B )(1 − TC )(1 − TS ) + rB B (1 − TB )

This can be rewritten as

 (1 − TC )(1 − TS ) 
EBIT (1 − TC )(1 − TS ) + rB B (1 − TB ) 1 − 
 1 − TB ) 
The total cash flow to all stakeholders in the levered firm is:
 (1 − TC )(1 − TS ) 
EBIT (1 − TC )(1 − TS ) + rB B (1 − TB ) 1 − 
 1 − T B 

The first term is the cash flow of A bond is worth B. It promises to pay
an unlevered firm after all taxes. rBB×(1- TB) after taxes. Thus, the value
Its value = VU. of the second term is:
 (1 − TC )(1 − TS ) 
B 1 − 
 1 − T B 
The value of the sum of these
two terms must be VL
 (1 − TC )(1 − TS ) 
VL = VU + 1 − B
 1 − TB 
Consider case where TB = TS, we are back to M&M with
only corporate tax:

 (1 − TC )(1 − TS ) 
VL = VU + 1 − B
 1 − TB 
VL = VU + TC B

Personal taxes does not affect the valuation formula as long as

equity distributions are taxed (TS) identically as interest at the
personal level (TB).

In other words, investors would be indifferent to holding

equity or debt as long as TS= TB.
Consider the case where TB > TS :
Interest receives tax deduction at the corporate level but is taxed
at a higher rate than equity income at the personal level.
If distributions to debt holders are taxed at a higher personal tax
rate (TB > TS ), the tax advantage of debt at the corporate level is
partially offset.
So 𝑉𝐿 < 𝑉𝑈 + 𝑇𝐶 𝐵 , the case where TB = TS

 (1 − TC )(1 − TS ) 
VL = VU + 1 − B
 1 − TB 
VL  VU + TC B
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Cont’d…
case where TB > TS
Interest receives tax deduction at the corporate level but is taxed
at personal level at a higher rate than equity income.

VL  VU + TC B

More taxes are paid at the personal level for a levered firm than
an unlevered firm. But there is still gain from reducing the
government’s share of the pie under certain conditions

 (1 − TC )(1 − TS ) 
VL = VU + 1 − B
 1 − TB 
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