Finance: Debt and Taxes Overview

Debt and Taxes

• Perfect capital markets have zero NPV transactions, neither creating nor destroying value. Debt vs. equity financing choices don't alter a firm's value in perfect markets. Leverage increases equity risk and cost of capital but doesn't impact overall firm value or share price.
• Real-world firms invest heavily in capital structure management, suggesting leverage significantly impacts value. Capital structures vary greatly among industries.
• In 2022, Vertex Pharmaceuticals had a very low debt-equity ratio (0.015), while Ford Motor and American Airlines had much higher ratios (2.1 and 4.3). These differing ratios are consistent with differences in industries.
• Modigliani and Miller's proposition explains that capital structure doesn't matter in perfect capital markets.
• Assumptions of a perfect capital market include:
• Investors and firms can trade securities at prices equal to their future cash flows
• No taxes, transactions costs, or issuance costs are involved.
• Financing decisions don't change a firm's investment cash flows or reveal new investment information.
• Corporate taxes reduce the amount of tax paid. Interest expenses reduce corporate tax obligations.
• Interest Tax Shield is the reduction in taxes due to interest payments, encouraging debt.

Macy's 2014 Income

• Macy's 2014 earnings before interest and taxes were approximately $2.8 billion.
• Interest expenses were roughly $400 million.
• Macy's 35% marginal tax rate determined that using leverage increased total investor income by $140 million.
• Net income with leverage was lower than without leverage, but the total income available to investors was higher.

Calculating Interest Tax Shield

• Interest tax shield calculation uses the formula:

Interest Tax Shield = Corporate Tax Rate × Interest Payments

• Example using DFB (D.F. Builders) financials (2023-2026):
• DFB's corporate tax rate is 25%.
• Interest expense figures for 2023-2026 were provided.
• Applying the formula for each year's interest expense generated the interest tax shield amount for that year; an example calculation for 2023 showed the interest tax shield as $12.5 million.

Valuing the Interest Tax Shield

• The present value of future interest tax shields determines the leverage benefit for the firm's value.
• Cash flows to investors increase with leverage by the interest tax shield amount.
• Valuing levered and unlevered firms implies the levered firm value (VL) equals the unlevered firm value (VU) plus the present value of the interest tax shield. VL = VU + PV (Interest Tax Shield)

The Repatriation Tax

• Apple's $17 billion in 2013 bond issuance stemmed from repatriating billions of $$ dollars in overseas earnings to avoid a high U.S. tax liability.
• Many firms held overseas cash and borrowed domestically to delay repatriation tax liability.
• The 2017 Tax Cuts and Jobs Act (TCJA) removed this incentive and resulted in the repatriation of $850 billion of overseas cash in 2018.

The Weighted Average Cost of Capital (WACC)

• WACC represents the firm's effective cost of capital after accounting for interest tax shield benefits. This value is lower than the pretax WACC.
• WACC relationship to pretax WACC (Pretax WACC) is illustrated by the formula: WACC = (E / (E + D))re + (D / (E + D))rd(1 - Tc)

###Optimal Capital Structure with Taxes

• Optimal leverage occurs when interest expense equals the level to maximize tax deductions. Further, optimal leverage decreases with growth rates as firms that grow faster have higher pre tax costs..
• Personal taxes on interest and dividends reduce the interest tax shield benefit, lowering firm value.