6. Taxes, Trade-off, Distress and Agency

Main effect of corporate taxes on debt financing

• Interest payments reduce taxable income and generate a tax saving

• This interest tax shield makes debt financing attractive relative to pure equity

Present value of a permanent interest tax shield intuition

• If the firm maintains a constant level of debt it receives a repeating stream of tax savings on interest

• The present value of this stream increases firm value by an amount proportional to the level of debt and the tax rate

MM Proposition 1 with corporate taxes in words

• With corporate taxes a levered firm is worth the value of the same firm without debt plus the present value of interest tax shields

• Debt can therefore increase firm value

Effect of increasing leverage on WACC with only corporate taxes

• As the firm uses more debt the tax shield lowers the effective cost of debt

• This reduces WACC and raises firm value until other frictions appear.

Who captures the tax benefit when a firm increases debt at fair prices

• If new debt is fairly priced the gain from the tax shield goes to existing shareholders

• Debt holders receive a fair expected return but no extra value

Tax shield as a separate asset on a market value balance sheet

• The present value of tax shields can be shown on the asset side as an additional asset

• Debt and equity values together must equal operating asset value plus tax shield value

After tax cost of debt definition

• After tax cost of debt is the effective return required by lenders after accounting for the tax deduction on interest

• It is lower than the stated interest rate whenever interest is tax deductible

Effect of issuing permanent debt on share price in theory

• Issuing permanent debt creates a tax shield and raises firm value

• If the number of shares stays constant the price per share increases by the gain divided by shares outstanding

Financial distress costs definition

• Direct costs are legal and advisory expenses in bankruptcy or restructuring

• Indirect costs include lost customers suppliers and employees and distorted investment decisions under distress

Static trade off theory of capital structure

• Firms choose leverage by balancing tax benefits of debt against expected costs of financial distress and other frictions

• Optimal leverage is where firm value is highest

Why high growth and intangible intensive firms often use less debt

• Their value comes largely from growth options and intangible assets that are hard to pledge as collateral

• Distress can destroy these assets so the expected cost of distress is high

Effect of higher business risk on optimal leverage

• More volatile cash flows raise the probability of distress for any given debt level

• This increases expected distress costs and reduces optimal leverage

Expected distress cost concept

• Expected distress cost equals the chance of distress multiplied by the loss in value conditional on distress

• It is subtracted from the firm’s value with tax shields in trade off models

Why WACC does not keep falling with leverage in reality

• At high leverage lenders demand higher interest rates covenants tighten and customers or suppliers may react negatively

• These effects raise costs and can outweigh tax benefits so WACC eventually rises

Asset substitution or risk shifting problem

• Highly levered equity holders may prefer very risky projects because they share in upside while debt holders absorb much of the downside

• Example firm swaps a safe positive NPV project for a very risky zero or negative NPV project

Debt overhang or underinvestment problem

• When existing debt is large shareholders may reject new positive NPV projects if most of the value gain goes to debtholders

• The firm then underinvests relative to the efficient level

Leverage ratchet effect

• Once leverage is high shareholders resist actions that reduce it because that would transfer value to debtholders

• They may still support more leverage even if firm value would be higher with less debt

Role of covenants in debt contracts

• Covenants limit actions that could hurt debt holders such as extra borrowing asset sales or large payouts

• They reduce risk shifting but also restrict managerial flexibility

How exchanging debt for equity can reduce distress costs

• A debt for equity swap lowers fixed interest obligations and spreads risk between former debtholders and shareholders

• This can avert default and preserve going concern value

Effect of secured debt on incentives

• Secured debt is backed by specific collateral which reduces potential losses for those lenders

• It can limit extreme risk taking on those assets but may increase risk borne by unsecured creditors

How personal taxes affect the advantage of debt

• If investors pay higher taxes on interest than on equity income personal taxes reduce the net tax benefit of debt

• In extreme cases they can fully offset the corporate tax advantage