The Interest Tax Shield

Capital Structure and Corporate Taxes

• In a less than perfect world, capital structure matters because it

affects a firm’s tax bill.
• Different financial transactions are taxed differently.

• For corporations (typically):

• Interest payments are considered a business expense, and are tax exempt
for the firm.
• Dividends are taxed.
MM With Taxes: Core Intuition

• Define the “size of the pie” as the value of before-tax cash flows.
• MM say: The size of the pie is unaffected by capital structure. This is
still true.
• But, with taxation, the government gets a slice too. The firm’s choice
of capital structure affects the size of that slice.
• Interest payments being tax deductible, the value of the government’s
slice can be reduced by using debt rather than equity.
The Firm as a Pie (or Pizza) Again

Equity

Taxes
Debt
MM With Taxes: Example
Consider our previous example (from the EPS fallacy) of an all-equity financed firm (10m
shares, ra = 10%). Assume now corporate taxes are τc = 40%.

Low Medium High

(expected)
EBIT ($m) 10 20 30
Interest payments 0 0 0
Taxes ($m) 4 8 12
Net Income ($m) 6 12 18
EPS ($) 0.6 1.2 1.8

12 1.2
VU = E = = $120m P= = $12
0.1 0.1
The Levered Firm
Suppose the firm announces an issue of $60m of perpetual debt, at a 7% coupon, and
uses the proceeds to repurchase shares.

Low Medium High

(expected)
EBIT ($m) 10 20 30
Interest payments ($m) 4.2 4.2 4.2
Pretax Income ($m) 5.8 15.8 25.8
Taxes ($m) 2.32 6.32 10.32
Net Income ($m) 3.48 9.48 15.48
TCF = NI + Int Total Cash Flow ($m) 7.68 13.68 19.68
UCF = EBIT (1 − τc ) Unlevered Cash Flow ($m) 6 12 18
ITS = τc × Int Interest Tax Shield ($m) 1.68 1.68 1.68

Equivalently, TCF = UCF + ITS or TCF = EBIT − Taxes

The Pie (Using Expected Cash Flows)

Equity
Equity
9.48
12

Debt
4.2
Taxes Taxes
8 6.32

Unlevered Levered
Total Cash Flows

• The total cash flow or capital cash flow is the cash flow that can be
distributed to investors – both debt holders and equity holders.
• These are also sometimes called free cash flow (to the firm),
although we will reserve this term for something else.
The End
Levered Firm Value
Levered Firm Value in the Presence of Taxes
• The value of a levered firm is the present value of its expected total
cash flows.

VL = PV (TCF ) = PV (UCF ) + PV (ITS) = VU + PV (ITS)

• In our example:
12 1.68
VL = +
ra rits
• Which rate should we use to discount the interest tax shields?
• That is, what is the risk of the interest tax shields?
Discounting Tax Shields

Unlevered cash flow 6 12 18

Interest Tax Shield 1.68 1.68 1.68

• Note that the interest tax shield is much less risky than the UCF; it
does not seem right to use ra to discount the tax shield.

• Is it possible for the tax shields to fluctuate?

• Risky debt: you do not get tax shields if you default.
• Changing interest payments: if debt keeps changing in the future, interest
payments will fluctuate, and so will interest tax shields.
Discounting Interest Tax Shields

• For any financial policy that implies a predetermined interest

payment schedule (i.e., we know with certainty the interest we will
need to pay), we use the cost of debt to discount the interest tax
shields:
rits = rd

• Intuition:
• The only risk associated with tax shields is default risk.
• rd adjusts for default risk
The Value of the Levered Firm
12 1.68
VL = VU + Vits = + = $144m
0.1 0.07

• Note that since the debt is perpetual, we could also have calculated
the value of the tax shield as:
D × rd × τc
Vits = = D × τc = 60 × 0.4 = $24m
rd

• Assuming perpetual/permanent debt, levered firm value becomes:

VL = VU + D × τc
The Value of the Levered Firm
Comments

• Raising debt does not create value in and of itself, ie, you can’t
create value by just borrowing and sitting on the excess cash.
• Debt only creates value via tax shields relative to raising the same
amount in equity.

• Hence, value is created by the tax shield when you:

• Finance an investment with debt rather than equity.
• Undertake a recapitalisation, ie, a financial transaction in which some equity
is retired and replaced with debt.
The End
Financial Distress Costs and Trade-Off Theory
Agenda

1. Financial Distress

2. Trade-Off Theory
Leverage and Financial Distress

If increasing debt increases the value of the firm (via interest tax
shields), why not shift to 100% debt?

• With more debt, there is a greater chance that the firm will default on
its debt obligations. A firm that has trouble meeting its debt
obligations is in financial distress.
• Getting into financial distress may impose additional costs for the firm
– costs of financial distress (CFD) – that destroy firm value.
Direct and Indirect Costs of Financial Distress
Direct costs:
• Legal and administrative costs of bankruptcy
• Average direct costs are 3-4% of the pre-bankruptcy market value of total assets
(many costs are fixed).

Indirect costs:
• Examples include:
• Loss of customers, suppliers, and employees
• Fire sale of assets
• Deterioration of competitive environment
• Just the threat of bankruptcy can generate these costs.
• Difficult to measure accurately, and often much larger than the direct costs of
bankruptcy.
Trade-Off Theory
• Trade-off Theory: The optimal leverage should balance the
incremental benefits and costs of debt.

• How do you quantify this trade-off?

VL = VU + PV (ITS) − PV (CFD)

where the present value of the expected financial distress costs can
conceptualised as:

PV (CFD) = Prob of distress × CFD(when it happens)

Optimal Leverage and Trade-Off Theory
The End
Other Leverage Effects
Agenda

1. Debt and Agency Conflicts

2. Debt and Asymmetric Information

Agency Conflicts

• The managerial entrenchment problem (ie, the

shareholder-manager agency conflict) is most severe in firms with
dispersed ownership and lots of excess cash. Debt provides
incentives for managers to run the firm more efficiently:
• Ownership remains more concentrated, improving monitoring of
management.
• Since interest and principal payments are obligations, debt reduces the
cash available at management’s discretion to use wastefully.
• Managers have an incentive exert greater effort, since they will likely lose
their jobs in the event of bankruptcy.
Agency Conflicts

• Equity-Debt Holder Conflicts: a conflict of interest exists if

investment decisions have different consequences for the value of
equity and the value of debt.
• Most likely to occur when the risk of financial distress is high.
• Managers may take actions that benefit shareholders but harm creditors
and lower the total value of the firm.
• Inefficient risk-taking (‘risk-shifting’)
• Under-investment problem
Debt and Asymmetric Information

Managers’ information about the firm and its future cash flows is likely to be
superior to that of outside investors.
• Signaling theory of debt: managers can use leverage as a credible
signal of good information to convince investors that the firm will
grow, even if they cannot provide verifiable details.
• Market timing: Managers sell new shares when they believe the
stock is overvalued, and rely on debt and retained earnings if they
believe the stock is undervalued.
Adverse Selection and the Pecking Order Hypothesis
Suppose managers engage in market timing (ie, issue equity when it is
overpriced):
• Knowing this, investors will discount the price they are willing to pay
for the stock.
• Managers do not want to sell equity at a discount so they may seek
other forms of financing.
The Pecking Order Hypothesis states:
• Managers have a preference to fund investment using retained
earnings, followed by debt, and will only choose to issue equity as a
last resort.
The End