Taxes And Payout Policy

The Modigliani-Miller Theorem is a foundation of modern corporate finance. At its core, the theorem is an irrelevance proposition: The Modigliani-Miller Theorem provides conditions under which a firm’s financial decisions do not affect its value. Modigliani and Miller stated:… with well-functioning markets (and neutral taxes) and rational investors, who can ‘undo’ the corporate financial structure by holding positive or negative amounts of debt, the market value of the firm – debt plus equity – depends only on the income stream generated by its assets. It follows, in particular, that the value of the firm should not be affected by the share of debt in its financial structure or by what will be done with the returns – paid out as dividends or reinvested (profitably). There are 4 distinct propositions by MM. Under certain conditions, a firm’s debt-equity ratio does not affect its market value. A firm’s leverage has no effect on its weighted average cost of capital (i.e., the cost of equity capital is a linear function of the debt-equity ratio). Firm market value is independent of its dividend policy. Equity-holders are indifferent about the firm’s financial policy. The MM propositions rest over many assumptions: Capital Markets have to be well functioning. This means that investors can trade securities without restriction and can borrow or lend on the same terms as the firm. Each firm’s financial policy conveys no new information about the pattern of its earnings. Absence of bankruptcy. It means the earnings always exceed the debt obligations. Every firm is assigned to a risk class. A risk class is defined as a set of firms each of which has an identical pattern of earnings payoffs across the world. Thus the levered and unlevered all belong to same risk class. Capital markets are efficient, so that securities are fairly priced given the information available to investors. There is no distorting tax and it ignores the cost encountered if a firm borrows too much and land in financial distress.

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TAX BENEFIT DUE TO DEBT POLICY We will start with considering a firm working in an ideal environment where all the above assumptions are taken in consideration, mainly the firm is not paying any tax. Consider a firm which has invested in some productive asset which allows it to generate an income (as the earning before interests and taxes (EBIT)” E” at each time “T”. Roughly speaking, E is equal to the value of the sales minus production costs. In real world, when positive, E is used to pay bondholders (coupon), government (tax), and equity holders (dividends). Let VL (T) be the value of the levered firm at a given time T. We shall now compute VL (T) under various scenarios. Unlevered firm In this simple case, in which C = 0, the value of the unlevered firm at time T, Value of the unlevered firm VUL (T) is: VUL (T) = E Levered firm with no default risk. We say that the corporate bond is risk-free if the coupon is paid at any time T to bondholders with probability one. In the risk-free case, the net result (E - C) is positive with probability one so that the value of the levered firm at time T is: VL(T) = C + (E - C) =E = VUL(T) When there is no corporate income tax, the value of the levered firm (at time T) is equal to the value of the unlevered one (at time T), i.e., the value of the firm is invariant with respect to C as long as the coupon implies no default risk. This is the Modigliani-Miller theorem without default risk. Further approaching the MMs proposition 2: the behavior of cost of equity which states the expected returns required by the share holders of a geared company. Given that E/(Vs+Vb) = E/Vo = WACC-----------------------------------------(1) And Re = (E-C)/Vs---------------------------------------------------(2) We may write E = WACC * Vo = WACC (Vs + Vb)---------------------------------(3) Substituting for E, Re = ( WACC (Vs + Vb) – C)/ Vs Re = (WACC * Vs + WACC * Vb – C)/Vs Re = WACC + (WACC - C/Vb)/(Vb/Vs) Re = WACC + (WACC – Rd) / (Vb/Vs)

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Since proposition 1 argues that WACC equals return required by the shareholder in an equivalent un-geared company therefore: Rg = Re + (Re –Rd) Vb/Vs Where: E: earnings C: coupon rate WACC: weighted average cost of capital Rg: returns required by share holders of geared company Re: returns required by share holders of un-geared company Rd: return required by providers of debt capital Vb: market value of company’s outstanding borrowing Vs: value of share holder stake in the company Vo: total value of the firm It simply tells us that rate of return required by shareholders increase linearly as the debt/equity ratio in increased i.e. cost of equity rises exactly in line with any increase of gearing to offset precisely any benefits conferred by the use of any apparently cheap debt.

Rg = Re + (Re –Rd) Vb / Vs

WACC

Required return

Rd

Vb / Vs

Now let us consider the corporate world where the tax is levied on the earnings. Unlevered firm. In this simple case, in which C = 0, the value of the unlevered firm at time T, denoted VUL(T), is:

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VUL(T) = E*(1 - Ta) where Ta be the corporate tax income. Levered firm, no default risk. In the risk-free case, the net result (E - C) (1-Ta) is positive with probability one so that the value of the levered firm at time T is: VL(T) = C + (E - C)*(1 - Ta) VL(T) = E*(1 - Ta) + Ta*C VL(T) = VUL(T) + Ta*C The value of the levered firm is equal to the value of the unlevered firm VUL(T), plus the value of the tax-shield Ta*C, which comes from the fact that interests expenses are tax-deductible. As seen form above the company value profile now rises continuously with gearing. With no corporate tax the share holder in a geared company require a return Rg of: Rg = Re + (Re – Rd) * (Vb/Vs) However in taxed world the return required by share holders becomes Rg = Re + (Re-Rd)*(1 – Ta)* (Vb/Vs) The premium for financial risk required by shareholders is lower in this version owing to the tax deductibility of debt interest, making the debt interest burden less onerous. It follows that if at every level of gearing the cost of equity is lower and also the cost of debt itself is reduced by interest deductibility, the WACC is lower at all gearing ratios and declines as gearing increases. WACC = Rg * Vs/(Vs + Vb) + Rd* (1 – Ta)* Vs/(Vs + Vb) which can further be written as? WACC = Re (1- (Ta * Vb)/(Vs + Vb)) Clearly there is significant advantages from gearing with the implication that company should gear up until 100 percent of its financing. However it is not possible or rather sensible given the high risks

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involved.

Rg

Re

Cost of capital WACC

Rd = C(1-Ta)

Vb/Vs

VL(T) = VUL(T) + Ta* C Ta * C

VUL(T )

VUL(T

Vb/Vs

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Another advantage of a tax shield to a leveraged firm is it can carry back the losses to receive amount of taxes paid in the previous 2 years, similarly it can carry forward the losses to receive tax credit in subsequent years.

Firms with low effective marginal tax rates prefer leasing to increase the value of its firm, where as firms with high marginal tax rates consider issuing high interest debt as its interest payment are non taxable.

TAX BENEFIT DUE TO PAYOUT POLICY Company’s dividend policy is a trade off between paying cash dividend, issuing equity and repurchasing stock. Lenders may impose some of the restrictions on the dividend payment in order to have enough cash to pay the capital. In order to maximize tax benefits, company may offer dividend reinvestment plans which permit the shareholders to reinvest their dividend to purchase additional shares in the company. This reduces the commission costs for the investors and provides a saving mechanism. It also acts as inexpensive means of raising equity capital for the firm’s investment plans. Capital gains are taxed at lower rates than dividend income. If the dividend income is at tax-disadvantage the investors will demand high pre tax dividend return on high pay out stocks. Instead of paying high dividends companies should choose the cash on repurchase shares to reduce the amount of the shares issues. In this way the company would be ineffect convert dividend income into capital gains. This is one reason low-dividend policy might be preferred. Taxes on dividends have to be paid immediately but taxes on the capital gains can be deferred until shares are sold and capital gains are realized. Stock holders can choose when to sell their shares and thus when to pay the capital gain tax. The longer they wait the less the present value of the capital gains tax liability. The corporations prefer dividends for tax reasons. They pay corporate income tax only on 30 percent of any dividends received. Thus the effective tax rate on dividends received by large corporation is 30 % of 35 %, or 10.5%. But they will have to pay 35% tax on the full amount of any realized capital gain. Thus with various mathematical and corporate practical application, it has been successfully discussed that the MM preposition, albeit very academic

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but does have a realistic implication of debt and payout policy on the firm’s value. References: Corporate Finance, Brealey, Myers and Allen. Corporate Finance and Investment, Decision and Strategy, Richard Pike and Bill Neale. Fundamentals of Corporate Finance, Brealey, Myers and Marcus. Modigliani-Miller, “The cost of capital, corporation finance and the Theory of investment” American Economic Review.

Anupam Moondra MSc. Shipping Trade and Finance 2008-09

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