Taxes and Financing Decisions Jonathan Lewellen & Katharina Lewellen
Overview Taxes and corporate decisions What are the tax effects of capital structure choices? How do taxes affect the cost of capital? How do taxes affect payout decisions? How do taxes affect firms’ real investment decisions? 2
Trade-off theory Firm value V U + tax shields Debt vs. equity: (1 – τ d ) vs. (1 – τ c )(1 – τ e ) V U + tax shields – distress costs Target capital structure Leverage 3
Main argument Internal equity is cheaper than external equity Cash distributions trigger personal taxes Tax deferral benefit of retained earnings helps offset the tax disadvantage of equity Our goal Quantify this effect Study the impact on capital structure, payout policy, and the cost of capital 4
Example Firm has $1 Distribute now Investors get (1 – τ e ), grows to (1 – τ e ) [1 + r (1 – τ i )] Distribute next year Grows to 1 + r (1 – τ c ), investors get (1 – τ e ) [1 + r (1 – τ c )] Retaining better if τ c < τ i Internal equity has tax benefits if τ c < τ i Trade-off: accelerate taxes vs. double taxation 5
Example This paper Clarify and generalize this idea (the example makes strong implicit assumptions) Miller (1977): (1 – τ c ) (1 – τ e ) > (1 – τ i )? Understand the implications for a firm’s capital structure, payout policy, and cost of capital 6
Overview Clarify the literature Capital structure Miller (1977), Hennessy and Whited (2004) Dividend taxes King (1974), Auerbach (1979), Poterba and Summers (1985) 7
Outline Simple model with two periods Discuss the literature Implications for corporate behavior Empirical estimates of the tax costs of equity 8
Model Study tax effects No agency conflicts, information asymmetries, or distress costs t = 0 t = 1 t = 2 Investment opportunity, Y Project pays Y + P 1 Liquidation Raise D 0 , S 0 Repay debt Equity distribution, δ 1 Cash: C 0 = D 0 + S 0 – Y Raise D 1 , S 1 Invest cash in riskless asset 9
Assumptions Debt is short term Risk neutral investors, interest rate = r Project return P 1 > Y r [no bankruptcy] Taxes Corporate tax rate is τ c , personal tax rates are τ i , τ dv , τ cg Capital gains taxed on realization (trading at t = 1 exogenous) Liquidating dividends not taxed on portion that represents capital repayment 10
Assumptions Classic tax system Corporate profits, after interest, taxed at τ c Personal income taxed at τ i , τ dv , τ cg Imputation system Personal tax credit for corporate taxes already paid on dividends Effectively: τ dv = 1 – (1 – τ i ) / (1 – τ c ) 11
Model Exogenous trading t = 0 t = 1 t = 2 Investors: Trade α of their shares Realize gains of α (V 1 – S 0 ) Tax basis = (1 – α ) S 0 + α V 1 12
Model Taxes t = 0 t = 1 t = 2 No taxes Corporate tax Corporate tax Capital gains tax on a Personal tax on fraction of shares dividends / liquidating repurchase Personal tax on dividends / repurchases 13
Tax effects Debt financing New external equity Internal equity / retained earnings 14
Cashflows Firm’s cashflows Arrival to date 1: C 1 = Y + P 1 (1 – τ c ) + ( C 0 – D 0 ) [1 + r (1 – τ c )] Exit from date 1: C 1 ′ = C 1 + D 1 + S 1 – δ 1 Arrival to date 2: C 2 = ( C 1 ′ – D 1 ) [1 + r (1 – τ c )] 15
Transactions at date 1 Proposition Issuing debt to hold as cash (i.e., to invest in the riskfree asset) has no effect on value, regardless of tax rates Implications Debt does not create value, via interest tax shields; only important if it changes equity Using cash to pay down debt doesn’t affect value either In transactions with equityholders, it doesn’t matter where cash comes from or goes to 16
Equity financing at date 1 External equity Raise S 1 at date 1 Shareholders’ CF 2 = π 2 + S 1 [1 + r (1 – τ c )(1 – τ e )] τ e is either τ cg or τ dv NPV Invest S 1 = $1 in the firm: 1 + r (1 – τ c )(1 – τ e ) Invest $1 outside the firm: 1 + r (1 – τ i ) 17
Equity financing at date 1 Proposition 2 (Miller)* If the firm uses repurchases, the tax benefit of external equity is: r [(1 – τ c )(1 – τ cg ) – (1 – τ i )] PV(S 1 ) = S 1 + − τ 1 r ( 1 ) i If the firm uses dividends, the tax benefit of external equity is: r [(1 – τ c )(1 – τ dv ) – (1 – τ i )] PV(S 1 ) = S 1 + − τ 1 r ( 1 ) i 18
Equity financing at date 1 Internal equity: retained earnings vs. repurchases Distribute all cash at date 1 CF 1 = C 1 – τ cg (C 1 – S 0 ) t = 1: Fully retain, distribute at date 2 CF 1 = – α τ cg (V 1 – S 0 ) t = 1: CF 2 = C 2 – τ cg (C 2 – TB 1 ) t = 2: [V 1 = PV(CF 2 )] 19
Equity financing at date 1 Proposition 3 The tax benefit of internal equity at date 1, or the PV of retained cash vis-à-vis a share repurchase, is − τ r ( 1 ) cg [ (1 – τ c )(1 – βτ cg ) – (1 – τ i ) ] PV(RE 1 ) = RE 1 + − τ − βτ 1 r ( 1 ) i cg where β = TB 1 / V 1 , the tax basis relative to current price when the firm doesn’t repurchase β determines how much tax is triggered by repurchase at t = 1 20
Equity financing at date 1 Case 1: β = 0 [ α = 0, S 0 = 0] Internal equity has tax benefit (better than debt) if τ c < τ i − τ r ( 1 ) cg [ (1 – τ c ) – (1 – τ i ) ] PV(RE 1 ) = RE 1 + − τ 1 r ( 1 ) i Trade-off If firm distributes at date 1, shareholders get C 1 (1 – τ cg ), grows to C 1 (1 – τ cg ) [1 + r (1 – τ i )] If firm retains the cash, it grows to C 1 [1 + r (1 – τ c )], shareholders get C 1 (1 – τ cg ) [1 + r (1 – τ c )] 21
Equity financing at date 1 Case 2: β = 1 [accrual taxation, α = 1] Internal and external equity are equivalent − τ r ( 1 ) cg [(1 – τ c )(1 – τ cg ) – (1 – τ i )] PV(RE 1 ) = RE 1 + − τ − τ 1 r ( 1 ) i cg r ≈ RE 1 [(1 – τ c )(1 – τ cg ) – (1 – τ i )] + − τ 1 r ( 1 ) i Intuition Payout triggers no new taxes → no deferral benefit Shareholders pay tax on first-period earnings regardless of payout decision 22
Equity financing at date 1 Proposition 4: Retained earnings vs. dividends With dividends, the tax benefit of internal equity at date 1, or the PV of retained cash vis-à-vis dividends, is − τ r ( 1 ) [(1 – τ c )(1 – ατ cg ) – (1 – τ i )] PV(RE 1 ) = RE 1 dv + − τ − ατ 1 r ( 1 ) i cg Observations 1 – τ dv in numerator not 1 – τ cg α not β in brackets Tax cost of dividends depends, in sign, on τ cg not τ dv 23
Equity financing at date 1 Why is ατ cg important? Suppose α = 0 Example from introduction: dividend tax is a sunk cost − τ r ( 1 ) [(1 – τ c ) – (1 – τ i )] PV(RE 1 ) = RE 1 dv + − τ 1 r ( 1 ) i If α > 0 Same except shareholders also pay capital gains taxes at t = 1 determined by α τ cg 24
Interpretation Impact on capital structure? Impact on payout policy? Impact on the cost of capital and investment? 25
Capital structure Trade-off theory No distinction between internal and external equity Target leverage ratio Tax cost of equity depends on (1 – τ c )(1 – τ e ) – (1 – τ i ) [ τ e ambiguous; avg. of τ dv and τ cg ] 26
Capital structure Our results Internal equity generally less costly than external equity Equivalent only if α = β = 1 and either 1: Firms use repurchases 2: Firms use dividends and τ cg = τ dv [with dividends, internal equity is cheaper if α τ cg < τ dv ] [King, 1974; Auerbach, 1979] 27
Capital structure Our results Incentives to lever up smaller than often assumed For firms with internal cash, trade-off between debt and retained earnings, not debt and new equity Dividends: (1 – τ c )(1 – ατ cg ) – (1 – τ i ) Neither depends on τ dv (1 – τ c )(1 – βτ cg ) – (1 – τ i ) Repurch: Profitable firms (w/ internal cash) should have lower leverage Internal equity may have tax benefits even if firms never want to issue new equity 28
Capital structure Our results No target debt ratio Debt ratio should be a function of internal cashflows Leverage up when the firm has a cash deficit, down when it has a cash surplus Pecking order? 29
Payout policy Dividend puzzle Form: why do firms use dividends not repurchases? Timing: why do firms pay dividends vs. retain the cash? τ dv vs. τ cg Observation 1 Retaining good if (1 – τ c )(1 – ατ cg ) – (1 – τ i ), which doesn’t depend on dividend taxes Observation 2 Inconsistent with view that profitable firms have too little leverage 30
Cost of capital Trade-off theory D (1 – τ c ) r D + V E r E WACC = V 31
Cost of capital Our results Cost of capital also depends on the firm’s mix of internal and external equity Dividends Repurchases r (1 – τ i ) / (1 – τ dv ) r (1 – τ i ) / (1 – τ cg ) External equity r (1 – τ i ) / (1 – ατ cg ) r (1 – τ i ) / (1 – βτ cg ) Internal equity Cost of internal equity doesn’t depend on τ dv Investment-to-cashflow sensitivity Cost of capital ≠ expected stock return 32
Recommend
More recommend
