Limits to the Use of Debt

1
Lecture 16

• Limits to the Use of Debt

2
Personal Taxation of Corporate Income
While the corporate tax favors debt, the personal
tax favors equity.
Dividends, like interest, are taxed as ordinary
income, but capital gains are taxed at
preferential rates and only upon realization.
Income used to repurchase shares, or retained to
invest in positive NPV projects, will lead to
capital gains on shares.
Capital gains equal the income that could
otherwise be paid as dividends while leaving
share prices unchanged.
Taxing capital gains only after realization
amounts to delaying the tax bill without charging
interest.
However, inflation raises the effective tax rate
on capital gains by incorrectly measuring nominal
gains as real income.
While nominal interest receipts are taxed, the
nominal interest payments are deducted by
corporation. Hence the net effect of inflation
is smaller.
3
Gains from Leveragewith both Corporate and
Personal Taxes
Total after tax cash flow to all investors
(after-tax cash flow of
an unlevered firm) has value The market value of
must be B
4
Gains from leveragewith both Corporate and
personal Taxes (continued)
Figure 1 Firm value as a function of leverage
5
Non-tax effects of leverage
Payments on debt are a legal obligation, but may
be impossible to be paid.
Figure 2 Payoffs to investers as a function of
firm value
Debt and equity are both contingent claims and
can both have risk.
6
1. Cost of financial distress
Direct legal, administrative and accounting costs
of bankruptcy are about 3 of liquidated firm
value.
7
2. Incentive to take large risks
8
2. Incentive to take large risks (continued)
9
3. Incentive to under-invest
Now suppose Loan Shark finds a government project
costing 300 with immediate payoff of 350.
Hence, project NPV50.
The government requires equity to fund the
additional 100 (in excess of cash) needed to
undertake the project.
The total market value of the firm with the
project is 350 200 (cash) 100 (new
equity) 50 (NPV of project) which is
divided as follows S 350 - 300 50
B 300
Shareholders therefore invest 100 for 50 value!
Bondholders capture 50 from shareholders and
50 from the riskless investment. Thus,
shareholders would refuse the project even if it
has positive NPV.
10
4. Non-financial benefits of debt
Low debt may also impose non-financial costs for
shareholders.
Employees get 100 of the benefits of shirking
while bearing less than 100 of cost.
Debt may initially raise firm value by providing
net tax benefits and reducing employee shirking
but eventually will decrease firm value by making
bankruptcy more likely.
11
Optimal Amount of Debt
Cost of financial distress and agency costs will
differ across firms.
Hence, optimal level of debt can also vary
substantially.
No exact formula is available for evaluating the
optimal debt-equity ratio, so must turn to real
world evidence.
12
Empirical Evidence
Many firms paying taxes have low debt ratios, and
thus dont seem to fully exploit the debt tax
shield.
13
Empirical Evidence (continued)
Systematic factors can explain some industry
differences

• Large physical investment suitable as collateral
  reduces borrowing rate.
• Large human capital investments make it costly to
  borrow.
• Firms with uncertain cash flow face a higher
  probability of bankruptcy from debt. Ex. Drug
  companies.
• Equity finance is more compatible with financing
  investment from retained earnings -- dividends
  can be changed or share repurchases shelved, if
  good opportunities arise.
• High future income raises current share prices,
  but interest deductibility is limited to the
  extent of current profits. Therefore, maximum
  debt would be less than 100 in high growth firm.

14
Claimants on Firm Cash Flows
Debt and equity are marketed claims and determine
the firm values. On the other hand, taxes and
bankruptcy costs and others are non-marketed
claims.
Financial markets encourage maximizing the total
value of marketed claims, partly by minimizing
non-marketed claims.
15
Tax Clienteles

• Marginal personal tax rates differ under
  progressive taxes.
• 0, 15, 28, 31, 36, 39.6

Some investors, such as corporate pension funds,
IRAs, and universities, face a zero tax rate on
interest and dividend income.
Ignoring risk considerations, investors would
tend to sort themselves into categories holding
assets with different tax liabilities.
16
Tax Clienteles (continued)
17
Example
What is the range of possible debt-equity ratio?
18
Example (continued)
19
Example (continued)
Equilibrium B/S for economy ranges between its
value if the marginal investors, (accounting
majors) all held stocks or bonds.
20
Example (continued)
21
Example (continued)