45
Lecture Notes Financial Policy Prof. Josef Zechner Spring 2008
Lecture Notes
Financial Policy
Prof. Josef Zechner
Spring 2008
2
1 Introduction
Financial Policy mainly deals with .the optimal structure of the channels on the right-
hand side of this graph. The left-hand side will be covered in Corporate Finance 2.
• dividend policy,
• capital structure policy and
• corporate hedging.
Each of these topics will be analyzed both in the context of (i) perfect capital markets
and (ii) imperfect capital markets with asymmetry of information.
Perfect capital markets are characterized by:
• No frictions: no transaction and agency costs, no taxes and no restrictions on
short sales
• No informational asymmetry: Information is costless, and it is received
simultaneously by all individuals
3
• Completeness: All assets are marketable1 and divisible
• Competitiveness: all investors and firms act as price takers
Consider the following assets:
asset cash flow, state 1 cash flow, state 2
1 10 20
2 5 10
3 15 30
What must be satisfied by the prices of these assets in the absence of arbitrage
opportunities!2
After analyzing the above-stated issues in the context of perfect capital markets, we will
allow for taxes, transaction costs and asymmetric information between
• the “firm” and the capital market
• the management and the share-holders
• the management and the debt-holders
1 More precisely, for a discrete case number of states equals number of linearly independent assets 2 In fact, absence of arbitrage opportunities roughly implies that the “price function” is linear over cash
flows.
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Part I
Dividend Policy
2 Who decides How Much and When?
• in Austria and Germany: usually 1 dividend payment per year.
− the general meeting (Hauptversammlung) decides on the dividend
payments - this payment is made to anybody who holds the company’s
stock on the ex-dividend date3
− the decision to pay a dividend is published (Wiener Zeitung),
− Dividend payments: the company prepares a list of all persons and
institutions who are entitled to the dividend, i.e. who own stock on the
ex-dividend date
− finally the payment is made
• US: usually 4 dividend payments per year
− announcement date: the CEO decides on the dividend payment - this
payment is made to anybody who holds the company’s stock on the
“date of record”
− ex-dividend date: 2 business days before the date of record
− date of record: the company prepares a list of who is entitled to the
dividend
− payment date
3 The date, after which shares are traded at the market without dividends (dividends are excluded), i.e. anyone who purchases the stock on or after the ex-dividend date will not receive the dividend
5
Dividend and share repurchase: two alternative ways of distribution
Some observations:
• Dividend payout ratio declined from 22% to about 14%
• Repurchase payout ratio increased from about 3% to about 14%
• The total payout of cash to shareholders was relatively stable at about 25% of
earnings
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Repurchases and Number of Firms by Year
0
20000
40000
60000
80000
100000
120000
140000
160000
180000
200000
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
0
200
400
600
800
1000
1200
1400
Repurchases (Nominal Volume) Number of Firms
Source: Dittmar and Dittmar ,“The Timing of Stock Repurchases”, working paper, 2006. Data are obtained from Compustat and represent the sum over the calendar year of Compustat item 115, less any decrease in preferred stock. Repurchase data are expressed in millions of dollars.
Some Observations:
• Repurchases increased considerably in nominal terms, during last 3 decades
• Number of firms distributing cash via repurchases was increasing till 2000, after
that decline is observed.
Dividend smoothing: the case of Chevron
Some observations:
• Dividends per- share was more stable than earnings and cash flows per share
• Dividends seem to be more correlated with cash flow than with earnings
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Chevron:Earnings,Cash Flows, and Dividends 1990-2006
0
2
4
6
8
10
12
14
16
18
20
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
0,00
0,50
1,00
1,50
2,00
2,50
3,00
3,50
4,00
4,50
Earnings per Share Cash Flow per Share Dividends per Share
Based on Chevron’s Annual Reports. Cash flow per share is calculated by dividing cash flow from operating activities on the number of common shares outstanding at the end of the year. Dividend policies of selected US firms
Some observations4
• Both dividend yields and payout ratios declined
• High-tech growth firms had lower dividend yields and dividend payout ratios
than the old-economy firms did.
4 According to Lintner, who has conducted classic series of interviews with corporate managers about their payout policies, firms have long term target payout ratios, dividend changes follow shifts in long-run sustainable earnings, and they repurchase stocks, when they have accumulated a large amount of unwanted cash.
8
Dividend policies around the world
One observation: Firms in civil law countries pay significantly lower ratios of dividends
to their shareholders than their counterparts in common law countries.
9
Source: La Porta, F.Lopez-de-Silanes, A. Shleifer and R. Vishny 2000, JF.
10
3 Is Dividend Policy Irrelevant? Miller, Modigliani, “Dividend Policy, Growth, and the Valuation of Shares” Journal of Business, 1961 Consider the following balance sheet:
current assets debt fixed assets
capital stock profit carried forward revenue reserves
What is the implication of an increase in dividends?
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In order to analyze dividend policy in a perfect capital market with homo-
geneous beliefs on part of the investors, we conduct a controlled experiment:
Consider a corporation in the world of perfect capital markets and homogeneous
beliefs on part of the investors. Let’s abstract from taxation. Suppose that the value of
this company at the end of year 1 is 1000. There are 100 shares outstanding and the
company has just earned a cash flow of 60. The management considers (i) a dividend of
60, (ii) 120 or (iii) zero. Except for the current dividend payment, the management has
already fixed the future dividend policy (investment per year: 90). Operating profits =
150.
dividend policy low dividend high dividend share repurchaseAnnual investment I operating profit X dividend payment nD dividend per share D issuance of shares mP=I-X+nD firm value (exD) V number of old shares n value of old shares (exD) nP=V-mP share price P number of new shares m value per share P+D
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Intuition: Under the assumptions of
• No Taxes
• Symmetric Information
• No Agency Problem among Managers and Equityholders
• No Transactions Costs
• Complete Markets
the dividend policy is irrelevant. The availability of external finance in this idealized
world of perfect capital markets and homogeneous beliefs makes the investment policy,
the “real” decisions of the firm, independent of the dividend policy. Since the equity
holders are indifferent between dividends and capital gains (realized when the equity-
holder liquidates her holding) in this idealized world, the dividend policy does not affect
the share price.
Notation:
V1, firm value at the end of the year
P0, share price at the beginning of the year
P1, share price at the end of the year
n, number of shares at the beginning of the year
m, number of new shares
X, cash flow at the end of the year
I, investment at the end of the year
D, dividend per share at the end of the year
r, discount rate
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Identities:
mP1 = I + nD - X
(n + m)P1 = V1 i.e. mP1 = V1 - nP1
Substitute for mP1:
Rearranging yields:
P1 =
This implies for the share price at the beginning of the year:
P0 =
Now we relax the first of the assumptions that made dividend policy irrelevant
and allow for taxation. The basic aim of the tax-related literature on dividends has been
to investigate whether there is a tax effect: Other things being equal, are firms that pay
out high dividends less valuable than those which pay out low dividends?
4 Taxation Notation:
• tc: corporate tax on retained and distributed earnings,
• td: income tax on dividend income,
• tg: income tax on realized capital gains,
• Π: profit before taxes.
There are two basic types of tax regime that differ with respect to the possibility of
double-taxation of corporate income.
4.1 “Classical” Tax Regime: e.g. US, Austria
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If the company distributes its profit, the equityholders’ after tax payoff is:
If the company retains its profit, the equityholders’ after tax profit is:
What should the company do?
In the US before the Tax Reform Act, td = tg. What should a US corporation have done?
4.2 Tax Credit System (Imputation System): e.g. Germany
before 2001
If the company distributes its profit, the equityholders receive after taxes:
If the company retains its profit, the equityholders’ after tax profit is:
What should the company do?
In Germany the corporate tax was 36% and the personal tax on capital gains zero, tg = 0.
What should a German corporation have done?
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4.3 Austria
In Austria, the corporate tax rate is 25 %. Personal taxation distinguishes between the
taxation of capital gains and that of dividend income.
Taxation of capital gains:
Taxation of dividend income:
Hence, the Austrian tax system creates the following three “clienteles”:
equity interest holding period td tg
I any < 12 months 25% marg. tax rate
II < 1% > 12 months 25% 0
III
> 1% (at any
point within last
5 years)
25%
1/2 avg. tax rate
What are the preferred dividend policies of the clienteles?
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4.4 The Static Clientele Model
In a clientele model, taxpayers in different clienteles want to hold different types of
assets that “cater to their needs”. We conduct the following thought experiment:
• Suppose that all companies in Austria pay out their entire profit as a dividend.
• Suppose that one Austrian corporation deviates and decides to retain its earnings
in the future. Which investors would most likely purchase this company’s stock?
What would happen to the stock price?
• In equilibrium:
Remark: Besides the static clientele model in which the investors are not
allowed to trade immediately before and after the dividend payment, there are
dynamic models in which this assumption is relaxed. These models are beyond
the scope of this course.
We now consider another imperfection which may undo the irrelevance of the dividend
policy:
5 Transactions Costs
There are several ways in which transactions costs may affect the dividend policy of a
firm.
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• From the perspective of the corporation: Dividend policy affects the expected
transactions cost due to the need to issue new shares in order to raise finance
• From the perspective of the equityholders: Dividend policy affects the expected
transactions costs because investors may have to trade in order to either create
home-made dividends or offset the dividend income
To sum up, transactions costs are both an argument in favour of and against dividends.
The dividend policy should be chosen to minimize the sum of the expected transactions
costs.
Another strand of explanations for dividend payments involves an asymmetry of
information between the management and the equityholders.
6 Asymmetric Information
Frequently, the management knows more about the future prospects of the company
than the equityholders do. There are some models which point out that managers may
use the dividend policy to signal information about the true value of the firm to the
capital market.
6.1 The Model by Miller and Rock
Miller, Rock, “Dividend Policy under Asymmetric Information”, JF 1985, 1031-1051.
• In this section, we assume that the capital market is informationally inefficient
• In order to focus on the implications of such inefficiency, we assume that there
are no taxes and no transactions costs
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• The model by Miller and Rock (MR) shows why the dividend policy may be
relevant in such a framework
• The model consists of two periods
– At time 0, the firm invests in a project the profitability of which is not
known to the equityholders. This initial investment, I0, is equity
financed.
– At time 1, the project produces a cash flow, CF1, which is used by the
firm to finance both its dividend payment, D1, and its intermediate
investment, I1. The cash flow is stochastic,
CF1 = F(I0) + 1~ε ,
where 1~ε denotes the random term. Neither the realization of the cash
flow nor the investment can be observed by the equityholders. Let the
time-1-value of the corporation cum dividend be denoted by V1(D1).
– At time 2, the proceeds of the investment, CF2, accrue. This cash flow is
positively correlated with the first-period cash flow,
CF2 = F(I1) + 2~ε with E ( 1
~ε ) = E( 2~ε ) = 0 and E( 2
~ε │ε1) = γε1(0 < γ ≤ 1).
Draw the “time line”!
• Assume that the management acts in the best interest of the equityholders. All
parties are risk neutral. For simplicity, abstract from discounting and taxation.
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Definition: Equilibrium
Equilibrium consists of
• a dividend and investment policy and
• a price function V1(D1) such that
– the management maximizes the return of the old shareholders and
– the value of the corporation V1 (D1) as perceived by the capital market is
equal to the true value of the corporation.
Numerical Example:
Assume that a firm may invest either 5 or 25 in order to earn a cash flow of 10
or 40 respectively one period later,
I0,1 Є {5,25} with F(5) = 10, F(25) = 40.
Suppose that γ = 1 and that ε Є {10, -10} with equal probability. What are the
possible realizations of 2~ε in the model of Miller and Rock?
How much will the firm invest at time 0?
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Suppose that all equityholders hold their shares until time 2. What dividend and
investment policy should the management pursue at time 1? How will the
dividend payment at time 1 affect the stock price (cum-dividend)?
Suppose now that the equityholders liquidate their holdings at time 1. Assume
that the management acts in the interest of the “old equityholders”. Characterize
an “equilibrium”, i.e. a dividend/investment policy which can be used by the
management in order to signal the future prospects to the equityholders and
influence the stock price at time 1!
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Conclusion: Companies with high expected future earnings pay a high dividend in order
to signal their bright prospects to the capital market. This signal is “costly” since the
companies have to cut back investment in order to be able to pay a high enough
dividend such that firms with lower earnings cannot mimic! This model offers an
explanation for the empirical observation that an increase in a company’s dividend
payments frequently raises the stock price.
Remarks:
• Such a signalling of future prospects is very important when the company wants
to issue new equity.
• This model cannot explain why companies seem to pursue a dividend policy
oriented towards long-run goals. The model is inconsistent with the fact that
companies change the level of the dividend payment relatively seldom given the
variation in the periodic cash flows (“dividend smoothing”).
7 Putting the Pieces together
We have seen various theories examining the corporate dividend policy. Important
factors guiding the managerial choice of a dividend policy are:
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• the attractiveness of different dividend policies for different tax-clientele(s),
• the minimization of transactions costs,
• the signalling of future prospects to the capital market.
If long-run earnings are smaller than expected, then the dividend payments can only be
held constant by issuance of new shares or a cut in corporate investment. Hence,
companies will alter their dividend policy.
If the corporate earnings decrease in the short-run but long-run prospects are as
expected, then the dividend policy will be held constant.
This is the case since the tax-clientele holding the shares of the corporation expects a
certain dividend payment.
Hence, any change in the dividend policy conveys important information to the market.
Changes in the dividend policy are therefore more “important” than the actual level of
dividend payments. This corresponds to the stylized facts that (i) firms seem to have
long-run target payout ratios and that (ii) managers seem to smooth earnings.
Empirical Evidence: Market responses to changes of dividend policy
Michaely, Thaler, and Womack, “Price Reaction to Dividend Initiations and Omissions:
Overreaction or Drift?”, Journal of Finance,1995
Two types of dividend policy changes are examined:
• Dividend initiation: First cash dividend payment reported on the CRSP Master File
(reinstitution of a cash dividend is not regarded as a dividend initiation).
• Dividend omissions: company that had paid regular, periodic cash dividends
announced to omit such payments.
Sample
• Data source: CRSP tapes
• Data coverage: All companies listed on NYSE and AMEX, excluding closed-
end funds and foreign companies, from 1964 to 1988.
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• 561 dividend initiation and 887 dividend omission events are identified.
Methodology: A typical event study
• Returns before, during and after the events are calculated and compared to four
benchmark portfolio returns.
• One benchmark is the equally-weighted CRSP index including dividends.
• The excess return for firm j from time period a to b is calculated as follows:
)1()1()( t
b
atjt
b
atbtoaj MRRER +Π−+Π===
where MR= return on the benchmark portfolio.
• The average excess returns for each period are calculated.
Main findings:
• The average performance of stocks that initiate dividends is significantly better
than the benchmark in the year prior to the initiation, with an excess return of
15.1%; while firms omitting dividends perform quite poorly in the year before the
omission declaration, with an excess return of -31.8%.
• During the three-day announcement period, the initiation portfolios experience a
significant excess return of 3.4%, while the omission portfolios have an excess
return of –7.0%.
• Firms replacing the cash dividend with a stock dividend have an excess return of
–21.9% in the year prior to the substitution announcement, -3.1% during the
event.
• The initiating portfolios continue to perform well in the following 1- and 3-year
period after the event, with an 1-year excess return of 7.5% and 3-year excess
return of 24.8%; while omitting portfolios continue to have bad performance,
with a 1-year excess return of –11.0% and 3-year excess return of -15.3%.
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• Firms replacing cash dividends with stock dividends perform especially poorly
after the event, with an average 1-year excess return of -15.2% and 3-year
excess return of -31.3%.
• A trading rule that shorts the firms declaring omission and longs the firms
declaring initiation generates positive returns in 22 out of the 25 sample years.
• There is little evidence for clientele shifts in the initiation as well as the
omission sample, which makes it unlikely that price pressure is a potential
explanation for the anomalous performance drift after the event.
What do we learn from this study?
• Dividend initiation and omission do convey important information about firm
performance.
• Investors seem to under-react to such changes of dividend policy. (an
opportunity for us to make money?)
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Part II
Capital Structure
8 Introduction
Consider the following balance sheet:
current assets
fixed assets
short-term
long-term
equity
obligations
obligations
The capital structure policy concerns the ratio of long-term obligations to equity. The
questions to be addressed are:
• Should the firm’s operating profit be distributed in the form of dividend
payments or interest payments?
• Why should the answer to this question be relevant?
9 When is the Capital Structure Relevant?
Consider the following example:
Consider a firm with the following market balance sheet:
assets
growth opportunities
D = 50
E = 50
V = 100
Suppose this firm (i) issues new debt amounting to 10 and (ii) pays a special dividend of
10. Then the new balance sheet looks like this:
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assets
growth opportunities
D(old) = 50
D(new) = 10
E =
V =
Assume that V = 105 and E = 45 after the issuance of debt and the payment of the
special dividend. Is this change in the capital structure in the interest of the
equityholders?
Consider an alternative: V = 100, D(old) = 45. What is the change in the wealth of the
equityholders?
As a conclusion, a change in the capital structure is in the equityholders’ interest when
either (i) the value of the firm increases or (ii) the value of the other securities issued by
the firm decreases. For now, we are going to focus on the relation between the capital
structure and the firm value!
10 Why could the Capital Structure Affect Firm
Value?
• Risk aversion of the investors:
– While investors with a high risk aversion tend to demand the debt issued
by the firm,
– Investors with low risk aversion tend to demand the equity issued by the
firm.
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Hence, it may make sense to split the firm’s cash flow in two streams of
different riskiness since this might increase the firm value.
• Taxation: Whereas interest payments are frequently deductible from the
corporate-tax-base, dividend payments do not create “tax-shields”.
• Signalling: The capital structure of a firm may convey information to the capital
market.
• Investment Incentives: The capital structure may affect the capital budgeting
decisions of the firm.
• Financial Distress: The capital structure determines the probability with which a
firm defaults on its obligations. When financial distress is costly, this is an
important determinant of the optimal capital structure.
As in our discussion of the dividend policy, we will first start out with an irrelevance
argument and then consider the various factor which make the capital structure decision
relevant in turn.
11 Modigliani and Miller (M&M)’s Proposition I and
Proposition II
Modigliani and Miller, “The Cost of Capital, Corporation Finance and the Theory of
Investment”, AER, 48, 261-297.
In the absence of taxes, bankruptcy costs, informational asymmetry, and when markets
are complete and efficient
“The market value of any firm is independent of its capital structure
and is given by capitalizing its expected return at the rate ρ
appropriate to its risk class.”
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• Suppose that Investor A holds a share α of the equity of an unlevered firm. Let
VU denote the firm value of this unlevered firm. Then investor A
– had to invest αVU and
– earns α(gross profit).
• Assume that this corporation issued debt and suppose that investor A changes
his portfolio to hold a share α of both the equity and the debt issued by the firm.
Let the total face value of debt issued by the firm be denoted by DL, let EL
denote the total equity value of the levered firm and let VL denote the firm value
after the issuance of debt. After restructuring his portfolio, investor A
– has invested αDL + αEL = α(DL + EL) = αVL and
– earns α(interest payment)+α(gross profit – interest payment) =
α(gross profit).
• Note that by using this strategy, investor A’s earnings are independent of
whether the firm is levered or not. As a consequence, in the absence of arbitrage
opportunities, it must be the case that
VU=VL.
• Suppose Investor B holds a share α of a levered firm. Let VL denote the firm
value. Then investor B
– had to invest αEL and
– earns α(gross profit — interest payment).
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• Now suppose that the corporation issues equity and uses the proceeds to pay
back its debt. How can Investor B restructure his portfolio by taking out a bank
loan in order to receive the same cash-flow as before?
After this restructuring, Investor B
– has invested αVU – αDL = α(VU – DL) and
– earns α(gross profit) – α(interest payment).
• Hence, Investor B’s earnings are independent of the firm’s leverage! In the
absence of arbitrage opportunities,
VU = VL.
Remarks on M&M Proposition I:
• Suppose a corporation issues only one type of security instead of two. This
reduces the “investment opportunity set”5 of the investors. This will not affect
the market value of the corporation if
– the investors (e.g. Investor A) do not need additional forms of
investment or if
– there are sufficient. alternative investments (e.g. Investor B’s bank
loan!).
5 The investment opportunity set is the set of securities from which the investors may choose.
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• Even in the absence of taxation and costs of financial distress, the capital
structure choice is relevant when the corporation offers a new type of security
which meets the not-yet satisfied demand of a certain clientele of investors. As
an example, corporations in the US or Japan sometimes issue “structured
products”, that is securities with embedded options such as “currency bonds”6.
Assume that the capital market is complete such that there is no demand for an
additional type of security. Then the firm value will be independent of the capital
structure in the absence of frictions such as taxation, bankruptcy costs, informational
asymmetry and etc. In such a world, what are the implications of M&M’s Proposition I
for the cost of capital?
Let
• kG denote the weighted average cost of capital (WACC) which is a weighted
average of
• kE, the cost of equity capital and
• kD, cost of debt capital.
Note that kD < kE. Can a corporation decrease its WACC by issuing additional debt?
In order to answer this question, we have to explore how the cost of equity capital
changes with the leverage.
• Note, that M&M’s Proposition I tells us that the firm value is independent of the
leverage. Hence, the firm value is given by
δ1cashflowexpectedV+
=
where δ is independent of the capital structure.
• In our notation, δ = kG. If we substitute for δ in the expression for the firm
value and solve for kG, we get
6 Such a currency bond is for example a bond denominated in USD together with the option to demand interest payment in JPY instead of USD!
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EDG kED
EkED
Dk+
++
=
since V = D + E and the expected cash-flow is given by (1+kD)D +(1+ kE)E. By
rearranging this expression, we get M&M’s Proposition II,
( )DGGE kkEDkk −+=
Hence, the cost of equity capital increases in the debt/equity ratio. Increasing the
leverage implies that the equityholders’ residual claim on the firm’s cash-flow becomes
more variable. Then equityholders require a higher rate of return in order to be
compensated for the risk they take.
11.1 A Synthesis of M&M and CAPM
Let
• βA be the systematic risk7 of the unlevered company,
• βE be the systematic risk of the equity and
• βD be the systematic risk of the debt capital.
Then,
EDE
EDD
EDA ++
+= βββ
or ( )ED
DAAE ββββ −+=
Hence, when the company is highly levered, then βD approaches βA. Consider the
following example:
7 Systematic risk is a risk, that cannot be reduced through diversification, as opposed to idiosyncratic risk
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Suppose that kG = 15% and kD = 10%. Tomorrow, can be described by the following
two possible states of nature:
state 1 state 2
prob. 0.5 0.5
Cash-flow 50 100
What is the return on the equity in either state when the company is all-equity financed?
What is the expected return on equity?
How does the return on equity change when the company issues a debt level of 20?
How does this change the expected return on equity?
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What is the reason for this increase in the expected return on equity following an
increase in the firm’s leverage?
11.2 Summary
• Many investors demand “leverage by debt-financing”. When the company does
not issue debt, then these investors (such as investor B) have to take out loans in
order to create “home-made leverage”. Whenever the transactions cost of doing
so exceeds that of corporate levering, the company should issue debt.
• Counter-argument: There are many companies that are levered anyway. Another
corporation becoming levered would not add to the investor’s existing
investment opportunity set and, hence, would not meet a not.-yet satisfied
demand. Hence, the firm value will not be affected!
• As a conclusion, financial structure matter whenever the corporation succeeds in
catering for a not-yet satisfied demand for investment opportunities. Is financial
structure irrelevant when this is impossible? No, there are other important
factors such as
– Taxes,
– Incentive Problems (Conflicts of Interest),
– Costs of Financial Distress, …
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12 The Tax-System and the Optimal Capital
Structure Decision
Swoboda, Zechner “Financial Structure and the Tax System” in “Finance” by R.a.
Jarrow, V. Maksimovic and W.T. Ziemba, Northholland, 1995.
Chapter 3 of Swoboda, “Betriebliche Finanzierung “, Physica, 1991
12.1 The Effect of Corporate Taxation under Certainty
Notation:
• EBIT: earnings before interest and taxes,
• VU, VL: firm value of an unlevered and a levered firm respectively,
• tc: corporate tax rate,
• D, I: debt level and interest payments of the levered corporation,
• kE, kD: cost of equity capital and debt capital respectively,
• The unlevered corporation’s EBIT are split into
– corporate taxes: tcEBIT and
– payoff of the equityholders: (1 – tc)EBIT.
Hence, the unlevered corporation pays a total of (1 – tc)EBIT to its investors.
• The levered corporation’s EBIT are split into
– interest payments I,
– corporate taxes tc(EBIT – I) and
– payoff of the equityholders: (1 – tc)(EBIT – I).
Hence, the levered corporation pays a total of
I + (1 – tc)(EBIT – I) = (1 – tc)EBIT + tcI
to its investors.
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• Now lets compare the firm value of an unlevered with that of a levered
corporation under the assumption that the earnings streams derived above are
perpetuities:
( )UE
cU k
EBITtV,
1−= versus ( )
D
c
UE
cL k
Itk
EBITtV +−
=,
1 ,
where KE,U = cost of equity capital of an unlevered firm. Since I = DkD, we have
VL = VU + tcD > VU. The levered firm can use “debt-tax-shields” in order to
reduce its tax burden and, hence, is more valuable than the unlevered firm.
• As a conclusion, leverage is beneficial in the presence of corporate taxation.
Why aren’t all corporations highly levered?
12.2 The Combined Effect of Corporate- as well as Personal
Taxation
12.2.1 The Classical Tax System
• As in the last subsection, corporate profits are taxed at tc, and corporate interest
payments are tax-deductible.
• In addition, interest payments as well as dividend payments are now taxable at
the personal level; the personal income tax rate is ti. Capital gains are taxed at
the rate tg.
• In the part “dividend policy”, it has been shown that the retention of corporate
earnings is optimal when tg < ti. Given this result, we now derive the optimal
capital structure policy:
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• Consider an unlevered corporation. The equityholders of such a corporation will
earn EBIT(1 – tc)(1 – tg) since the corporation will generally retain its earnings
after taxes.
• Now consider a levered corporation. Such a corporation pays
– (EBIT – DkD)(1 – tc)(1 – tg) to the equityholders and
– DkD(1 – ti) to the debtholders.
Hence, the investors of this corporation gain
EBIT(1 – tc)(1 – tg) + DkD[(1 – ti) – (1 – tc)(1 – tg)].
• When these earnings streams are perpetuities, then the firm values of an
unlevered and a levered firm compare as follows:
( )( )UE
gcU k
ttEBITV
,
11 −−=
( )( ) ( ) ( )( )[ ]D
gciD
UE
gcL k
tttDkk
ttEBITV
−−−−+
−−=
11111
,
Hence,
VL = VU + D[(1 – ti) – (1 – tc)(1 – tg)].
• As a conclusion, whether or not the firm should be levered depends on the tax
rates.
– If (1 – ti) < (1 – tc)(1 – tg) then the firm should remain unlevered.
– If (1 – ti) > (1 – tc)(1 – tg) then the firm should become levered.
• Criticism: Again, there is no interior optimal capital structure, i.e. a firm wants
to either to stay all-equity financed or to become completely debt financed! This
is not observed in reality!
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12.2.2 The Miller Equilibrium
Miller argues that the relevant marginal tax rates will adjust such that the capital
structure of any single firm is irrelevant. Suppose:
• tg = 0, tc = 0.5, kE = 0.04, there are individual investors with a personal income
tax rate ti = 0 (widows and orphans),
• all corporations are unlevered,
• the return on equity is realized in form of capital gain
What is these corporations’ cost of capital?
Can this be an equilibrium? Assume that one corporation deviates and issues debt
instead of equity.
• All investors with a personal income tax rate of zero will purchase this debt
when it yields at least kD = 4 %.
• What is the cost of capital of this corporation? What is the effect on the firm
value?
Upon observing this, other corporations decide to be debt-financed. When the number
of debt-financed firms has risen sufficiently, the demand of the investors in the zero tax-
bracket is satisfied. Hence, from that point on firms have to offer a higher yield in order
to attract additional investors.
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• As the face value of debt issued by the corporations increases, the demand by
the investors in the low tax-brackets will be exhausted. Hence, additional issuers
will have to “target” higher and higher tax-brackets:
– An investor with an income tax rate of mit will be indifferent,
between buying debt securities and equity if
kD(1 – mit ) = kE or m
i
ED t
kk−
=1
.
– Miller argues that the firms in an economy will continue to issue
additional debt until additional leverage is no longer beneficial in
terms of tax-savings, i.e.
mit = tc or
c
ED t
kk
−=
1
• In equilibrium, firms are indifferent between issuing debt and remaining
unlevered, VU = VL.
Graphically:
Example: Assume that there are four types of investors in the economy. The following
table gives the investment demand as well as the income-tax brackets of these investors:
investor type marginal tax rate wealth to be invested
doctors 60 % 3 billion
lawyers 50 % 1 billion
MBAs 40 % 0.5 billion
psychologists 0 % 0.1 billion
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Suppose that the corporate tax rate is 50 % and that kD = 0.1 and kE = 0.05. Moreover,
corporations can invest into projects yielding a return of 10 %. What group of investors
will invest in which security?
How much equity and how much debt will be issued in equilibrium?
Should there be additional debt issued?
Should there be less debt?
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12.2.3 The Situation in Austria
The following tax rates are currently applicable: ti = 0.25, tg is effectively zero and tc =
0.25.
State a condition such that leverage is optimal in Austria!
12.2.4 Imputation System
• Corporate profits are taxable at tc, and corporate interest payments are tax-
deductible.
• Interest payments and dividend payments are taxable at the personal level. The
corporate tax is deductible from investors’ personal tax on dividend payments.
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• The taxation of capital gains is either modest or zero at all.
Which dividend policy does such a tax-system imply?
• First consider corporations which pay dividends.
– The equityholders of unlevered companies gain EBIT(1 – ti).
– A levered company distributes the following after-tax cash flows to
its investors:
* (EBIT – kDD)(1 – ti) is paid to equityholders (after taxes) while
* kDD(1 – ti) is paid to debtholders (after taxes).
– Conclusion: Indifference.
• Now consider corporations which retain their earnings.
– The equityholders of unlevered corporations get EBIT(1 – tc).
– A levered company’s investors get:
* (EBIT – kDD)(1 – tc) in case of the equityholders and
* kDD(1 – ti) in case of the debtholders.
In total:
EBIT(1 – tc) + kDD(tc – ti).
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– The individual investors have the choice investing in the equity of a
corporation which pays dividends or in that of one which does not
pay any dividend.
* All investors for which ti < tc is satisfied are better off when
investing in a dividend paying stock.
* All investors for which ti > tc is satisfied will invest in a non-
dividend-paying stock.
What does this imply for the tax-rates which are relevant for the
management of a non-dividend-paying firm?
– In the case of a non-dividend paying firm: By comparing the total
earnings of the investors of an unlevered firm with those of the
investors of a levered firm, we see that the relation between the
relevant tax rates (stated above) implies: VU > VL. Hence, such
corporations should remain unlevered!
• Assume that there are both dividend-paying and non-dividend paying stocks in
the economy. Which securities are demanded by investors with ti < tc in
equilibrium?
• Which securities are demanded by investors with ti > tc in equilibrium?
12.2.5 Other Taxes
• trade tax (Gewerbesteuer):
– equity capital bears the full tax burden,
– debt capital bears only half the tax burden.
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• net worth tax (Vermoegenssteuer):
– the net assets (net worth) of a corporation is the tax base of the net
worth tax
– there is double taxation: (i) at the firm level, (ii) at the individual-
investor level.
12.3 The Effect of Taxation under Uncertainty
Up to now: The interest-tax-shields have been certain. However, when there is the
possibility that the corporation incurs a loss, then the tax-shields cannot be treated as
certain. The effect of such an uncertainty has been explored by De Angelo and Masulis.
See De Angelo, Masulis "Optimal Capital Structure under Corporate and Personal
Taxation," JFE ,1980.
Example: Let the corporate tax be given by tc = 0.5 and the income tax rate be given by
ti = 0.4. Moreover, kD = 0.1 and kE = 0.06. There are two equally probable states of
nature characterized by different earnings before interest and taxes (EBITDA):
state 1 state 2
EBITDA 100 200
depreciation 95 95
Determine the critical face value of debt such that the tax base in state 1 is equal to
zero!
