Discuss The Impacts of Taxation

When a firm faces new investment opportunities (or to keep its functioning) which have positive net present values, financing needs come along. The options range from using cash generated from operations to simply forego the projects. If the company wants to take its projects, when its cash is not enough, it can raise new funds from equity or debt. This combination of equity and debt which a company decides to use is known as its capital structure. This paper is about how a firm ought to establish its debt/equity ratio, focusing in the advantages and disadvantages of taxes’ impact on this ratio. Capital StructureWhen referring to the capital structure of a firm, it is impossible to avoid Modigliani-Miller’s (MM) influential paper â€Å"The Cost of Capital, Corporation Finance and the Theory of Investment† (1958). Later, they published several â€Å"follow-up† papers discussing these topics. MM set the foundations of the modern theory of capital structure. MM first hypothesis was that, under certain assumptions, the firm’s value is invariable despite relative changes in its capital structure, thus â€Å"a firm cannot change the total value of its outstanding securities by changing the proportions of its capital structure. † (Ross, Westerfield and Jaffe, 2001.p. 401).This is known as MM proposition I. In a general way this proposition is saying that a company cannot do something for its stockholders that they cannot do by themselves. The MM second proposition implies that the use of debt for financing increase the expected future earnings, but this increase is coupled with an increase in the risk to equity holders, thus the discount rate used to value these future earnings also increases. As Fabozzi and Patterson state â€Å"the increased expected earnings have on the value of equity is offset by the increased discount rate applied to these riskier earnings. †(2003)Mathematically the propositions can be stated: Pro position I: VU=VL where VU is the value of an unlevered firm and VL is the value of a levered firm. Proposition II: rs = r0 + B/S (r0 – rb) where rS is the cost of equity, r0 is the cost of capital for an all equity firm, rB is the cost of debt and, B / S is the debt-to-equity ratio. But these hypotheses rely on a â€Å"perfect market† assumption. When imperfections are present into a certain market this hypothesis is misleading. Changes in a firm’s capital structure could change the firm value. One of the most important market imperfections is the presence of taxes.Capital Structure and the Presence of Corporate Taxes In the previous sections is stated that the firm value is unrelated to its capital structure, i. e. it does not depend on its debt/equity ratio. But when taxes are incorporated into the analysis this affirmation is not true, â€Å"in the presence of corporate taxes, the firm’s value is positively related to its debt. † (Ross et al. 2 001. ) Thus, the use of debt has an advantage over financing with equity. The Internal Revenue Code (IRC) â€Å"allows interest paid on debt to be deducted by the paying corporation in determining its taxable income† (IRC code 1963 qt.in Fabozzi and Patterson. 2003. P. 598) This benefit is known as Interest Tax Shield, due to the fact that â€Å"interest expense shields income from taxation† (p. 602). This is TaxShield=(TaxRate)(InterestExpense) Now is necessary to value this shield and see how this changes the firm value. Taking account of the expression above it can be said that whatever the taxable income of a company is without debt, the taxable income is now less in an amount equal to the Tax Shield in the presence of debt. This idea is also based in MM ideas.In other words, the firm value is: Firm Value = Unleveraged Firm Value + Tax Shield Value Going deeply, this statement implies that all companies should choose maximum debt, something that can not be seen int o the real world. This is due to the presence of bankruptcy and other distress related costs that reduce the value of a levered firm. As a firm increases its leverage position these costs increase. There is a point when the present value of â€Å"these costs from an additional dollar of debt equals the increase in the present value of the tax shield.† (Ross et al. 2001. p. 432)This is the debt level which maximizes the firm value. Beyond this point the distress associated costs increase faster than the firm value due to additional debt. Therefore, there is a trade off between tax benefits and the financial distress costs. There is an optimal amount of debt for each firm, and this must be its debt objective level. Presence of Personal Taxes In presence of personal income taxes could decrease, or even eliminate, the advantage of corporate taxes associated with debt financing.Despite this, if the yields due to debt and stocks cause taxes at the same rate that the personal taxes, there is still an advantage coming from corporate taxes(Van Horne, 1997). Merton Miller proposed that, in presence of both, personal and corporate taxes, the decisions about capital structure of a firm were irrelevant (Miller, 1977). Despite this, personal taxes have different rates; therefore, with constant risk, individuals who are in the lower rate bracket must prefer debt and those who are at the upper part of the scale must prefer stocks.Fabozzi and Patterson summarize this point as follow: 1. If debt income (interest) and equity income (dividends and capital appreciation) are taxed at the same rate, the interest tax shield increases the value of the firm. 2. If debt income is taxed at rates higher than equity income, some of the tax advantage to debt is offset by a tax disadvantage to debt income. 3. If investors can use the tax laws effectively to reduce to zero their tax on equity income, firms will take on debt up to the point where the tax advantage to debt is just offset by the tax disadvantage to debt income.The bottom line from incorporating personal taxes is that there is a benefit from using debt. (p. 603) Small Literature Survey In this section it will be summarized some opinions and findings about capital structure decisions and taxes. Panteghini in a work about multinationals capital structure found that â€Å"optimal leverage is reached when the marginal benefit of debt financing (which is due to the deductibility of interest expenses) equates its marginal cost (which is related to the expected cost of default).A strategy used is â€Å"Income shifting† which â€Å"raises the tax benefit of debt financing, thereby stimulating debt financing, and delays default. † (2006) Verschueren research about Belgian companies strategies showed that â€Å"The hypothesis that firms for which the tax advantage of debt financing is higher have higher debt tax shielding ratios gets only meager support: more profitable firms have lower debt ta x shielding ratios. † She found â€Å"no indications that avoiding agency conflicts of any type plays a significant role in the determination of debt tax shielding. † (2002, p.22)She states that these results are quite close to international research also. Graham and Tucker found a similar result â€Å"Firms that use tax shelters use less debt on average than do non-shelter firms. † There is also a potential problem which is that â€Å"under-levered firms may have â€Å"off balance sheet† tax deductions that are not easily observable, and which are therefore often ignored in empirical analyses. † (2005 p. 1) Irina Stefanescu arrives to a comparable conclusion â€Å"There is a general consensus that significant tax incentives are associated with corporate borrowing.Nevertheless, many large and profitable companies with a low risk of financial distress have relatively low debt ratios. † (2006) Stewart Myers, explaining Miller’s paper â⠂¬Å"Debt and Taxes†, theorizes about why firms are not â€Å"awash in debt†Ã‚ · An interesting point he states is that Miller’s model â€Å"allow us to explain the dispersion of actual debt policies without having to introduce non-value-maximizing managers. In the other hand he states also that â€Å"Firms have good reasons to avoid having to finance real investment by issuing common stock or other risky securities.They do not want to run the risk of falling into the dilemma of either passing by positive NPV projects or issuing stock at a price they think is too low†. (1980) Conclusion It seems that several researches have been performed in capital structure decisions. Although not all of them arrive to the same conclusion it gives the impression that the tax shields have positive impacts on firms value; and the presence of personal taxes do not eliminate this fact.In the other hand, findings that companies have not larges amounts of debt indicates that t hey might obtain some advantages from other sources, e. g. off balance sheet benefits. After 48 years since Modigliani and Miller’s paper appeared, it can be said that â€Å"however, much remains to be done before the cost of capital can be put away on the shelf among the solved problems. † (Modigliani-Miller 1958)