II.

Capital Structure
and Corporate Tax

Structure
1. Debt and Taxes
2. Interest Tax Shield
3. Present Value of Tax Shield
4. Tax Shield and Company Value
5. Corporate Taxes and WACC

Is debt policy irrelevant?

Is debt policy irrelevant?

They all rely heavily on debt!

1. Debt and Taxes

Advantages

of debt financing:

Interest is a tax-deductible expense.

Equity income is subject to corporate tax.

1. Debt and Taxes - Example

Zero debt

$500.000 of
debt

$125.000

$125.000

$50.000

$125.000

$75.000

Tax at 35%

$43.750

$26.250

After-tax income

$81.250

$48.750

Combined debt and equity

income

$81.250

$98.750

Expected operating income

Debt interest at 10%
Before-tax income

1. Debt and Taxes - Example

Debt interest at 10%

Zero debt

$500.000 of
debt

$0

$50.000

$81.250

$98.750

Tax at 35%
Combined debt and equity
income

1. Debt and Taxes - Example

Debt interest at 10%

Zero debt

$500.000 of
debt

$0

$50.000

$81.250

$98.750

Tax at 35%
Combined debt and equity
income

Total

income increases by $17.500

Money spend on interest is not taxed:
$50.000 x 0,35 = $17.500 tax savings

2. Interest tax shield

These

savings are called interest tax

shield.
Annual tax shield = interest x tax rate
Annual tax shield = (debt x rD) x tax rate

2. Interest tax shield

Who

earns this money?

Debt investors?
Equity investors?

Debt

investors: fixed amount of interest

Shareholders:

the tax shield

receive all the benefits of

3. Present value of tax shield

Debt interest at 10%
Combined debt and equity
income
Annual tax shield:

Zero debt

$500.000 of
debt

$0

$50.000

$81.250

$98.750

$17.500

3. Present value of tax shield

Debt interest at 10%
Combined debt and equity
income
Annual tax shield:

Zero debt

$500.000 of
debt

$0

$50.000

$81.250

$98.750

$17.500
Bonds are replaced, debt is permanent

3. Present value of tax shield

Debt interest at 10%
Combined debt and equity
income
Annual tax shield:

Zero debt

$500.000 of
debt

$0

$50.000

$81.250

$98.750

$17.500
Bonds are replaced, debt is permanent
Present

value (PV) of the tax shield?

3. Present value of tax shield

Debt interest at 10%
Combined debt and equity
income
Annual tax shield:

Zero debt

$500.000 of
debt

$0

$50.000

$81.250

$98.750

$17.500
Bonds are replaced, debt is permanent
Present

value (PV) of the tax shield?

PV tax shield = $17.500 / 0,1 = $175.000

3. Present value of tax shield

PV tax shield = annual tax shield / rD
PV tax shield = (debt x rD x tax rate) / rD
PV tax shield = debt x tax rate

3. Assumptions of PV tax shield

1. Firm borrows permanently.
BUT: Firm may not take out a loan in one
year.

3. Assumptions of PV tax shield

2. Firm doesnt run in future losses and has
to pay income tax.
BUT: losses can occur

3. Assumptions of PV tax shield

3. Amount of debt is fixed.
BUT: rebalance of capital structure
(constant debt equity ratio)

3. Assumptions of PV tax shield

The formula overestimates the Present
Value of the tax shields.

4. Tax shield & company value

Zero debt

$500.000 of
debt

Expected operating income

$125.000

$125.000

Combined debt and equity

income

$81.250

$98.750

Return demanded by shareholders: 12,5%

Company value (zero debt):

$81.250 / 12,5% = $650.000

4. Tax shield & company value

Zero debt

$500.000 of
debt

Expected operating income

$125.000

$125.000

Combined debt and equity

income

$81.250

$98.750

Return demanded by shareholders: 12,5%

Present Value of tax shield:

$175.000

4. Tax shield & company value

The PV tax shield increases the todays
company value.

4. Tax shield & company value

Value all-equity financed: $650.000
PV tax shield:
$175.000
Total Value of company: $825.000

4. Tax shield & company value

Value of levered firm =
value if all-equity-financed + (debt x tax
rate)
+ (PV tax shield)

4. Tax shield & company value

Market
value

PV tax shield

Value if all-equity-financed

Debt ratio

5. Corporate Taxes & WACC

WACC = rE x
rate)

E
E+
D

+ rD x

E+
D

x (1- tax

Government pays 35% of interest costs,

so:
Firm has to earn the after-tax rate of
interest on its debts and the return
required by the shareholders.

5. WACC & Debt policy

Example:

Leverage affects a companys cost of

capital (if the company pays income tax).

5. WACC & Debt policy

Rates of
return
(%)
12,5%

r(equity)

WACC
after-tax return on debt: 10% x 0,35

15%

9,85%
6,5%

1,54
Debt-equity ratio
(D/E)

Implication of corporate taxes

for capital structure
Conclusions

Borrow as much as possible

Increase companys value
Minimize WACC

All

of the interest tax shield?

operating income used for interest

No income tax no more debts necessary

No equity income for shareholders