Impact of Tax on the Choice Finance Essay

The different combination of funds that a firm uses to finance its activities is known as capital structure. Capital can be raised either by using owners' claim (owner's savings, issuing ordinary shares or by retaining the earning) or creditors' claim (borrowings). In other words equity capital structure exists in two forms equity capital and debt capital. Tax affects investors' and managers' decision on capital structure choices as it decreases earnings. Graham (2003) states that both personal and corporate tax should be considered in order to analyze capital structure choices more accurately.

Debt refers to any fund that a company borrows with the intention to payback in equal installment over a fix period of time and the principle amount at maturity.

Advantages

After debt has been paid, the lender has no claim over the firm.

Interest paid to debt holders are tax deductible.

Disadvantages

Firm's cash flow must be enough to repay its debt.

Failure to debt repayment affects the credit rating and ability to obtain future financing.

Equity

Equity refers to the buying and holding of shares by individuals with an ownership interest. It can of two forms either ordinary or preference shares. Ordinary shares receive part of a firm's cash flow which is known as dividend after payments have been made to debt and preference shareholders.

Advantages

Permanent source of finance which do not have to be paid back.

Outside investors bring new ideas to explore and execute new ideas.

Disadvantages

Division of ownership and profit.

Potential investors seeking classified business information.

Debt-to-Equity Ratio (Leverage)

Leverage ratio measures the different fund raising opportunities by creditors and shareholders. Firms with higher debts than equity are considered to be highly levered. Too much debt are unsafe and risky as it out weights the firms' return and high level of equity indicates that the firms are not making the most productive use of its capital vis-à-vis leverage for obtaining cash.

For a firm to be considered sensible and credit worth it should have leverage ratio between 1:2 and 1:1. Managers often act opportunistically to reduce cost by taking tax advantage of debt financing.

Value relevance of capital structure choices and impact of taxation on finance has been to prior discussion.

Features of capital structure

Firms should choose a capital structure which is most appropriate to the firm. Such a decision can be taken only if the entire potential treat affecting the firm's capital structure decisions has been well analyzed and balanced. Factors affecting capital structure are as follows:

Nature of business

Characteristic of company

Management control

Cost of finance

Expected earnings in relation to interest changes

Availability of cash

Flexibility of capital structure

Risk

Capacity

Determinants of capital structure

Published theories and empirical evidence considers profitability, tax, NDTS, size, liquidity and tangibility are possible determinants among others in capital structure choice.

Size

Large firms are able to reduce transaction cost in the long run when raising capital. According to the trade-off theory, size and debt has a positive relationship as larger firms has stable cash flow, more dilute ownership and less prone to bankruptcy (Friend and Lang 1988) compare to smaller firms where there is shareholder-lender conflict (Titman and Wessels 1988).

Profitability

MM1 theory considered that profitability has no effect on leverage. Later on they found that since interest is tax deductible, large firms take advantage by issuing more debt. The trade off theory argues that profitable firms will borrow more to benefit from NTDS which postulates a positive relationship between profitability and leverage.

Liquidity

Firms with high liquidity borrow less. However, in market oriented economies a negative relationship between liquidity and leverage is expected as managers can manipulate liquid assets in the interest of shareholders by increasing the agency cost of debt.

Tangibility

The more tangible is a firm, the greater is its ability to secure debt (Booth et al 2001). Highly tangible firm reduces the risk of creditors and increases the value of assets in case of liquidation. However Brealey and Myers (1996) found a negative relationship between tangibility and short term debt.

Tax

Firms with higher tax rate should use more debt by having a higher leverage as it will have a higher income to shield from taxes. MacKie-Mason (1990) argued that "Nearly everyone believes that tax must be important in financing decision, but little support has been found in empirical analysis."

Non-Debt tax Shields (NDTS)

The attractiveness in debt financing is that a tax relief is allowable on interest payment. The net tax gain of the firm is the amount of interest payable. Expenses other than interest payment which are deductible from tax exemption like depreciation or investment tax credit are known as NDTS. DeAngelo and Masulis (1980) argue that NDTS reduces the potential tax benefit of debt financing. "Ceteris paribus, decreases in allowable investment-related tax shield due to changes in the corporate tax code or due to changes in inflation which reduces the real value of tax shields will increase the amount of debt that firms employ. Firms with lower investment related tax shield will employ greater debt in their capital structures."

Modigliani and Miller (1958) (MM1)

Over 40 years of pioneering work, the "Irrelevance Theory" of MM1 came with a simple definition that the value of the firm depends on the value of its real asset and the net cash flow generated by its assets rather than the cost of raising capital and the firm's capital structure by following these assumptions [1] :

Capital market is perfect (no tax or transaction cost).

Investors have perfect information and homogeneous expectations.

Investment decisions do not affect investment outcomes.

Managers work in the best interest of investors to maximize their wealth.

No bankruptcy cost.

MM1 demonstrated that the firm's value is determined solely by its cash flow and will remain unaffected irrespective of the firm's capital structure. Hence under a perfect capital market, any combination of securities would be as good as another by allowing complete separation of investment and financing decision. The value of a levered firm (both debt and equity) (VL) must be equal to the value of an unlevered firm (only equity) (VU).

VU = VL

The weighted average cost of capital (WACC) for each firm will also be constant as derived below:

WACC = rA = rd D/V + re E/V

Where rd and re are the cost of debt and equity respectively and D and E are the market value of debt and equity relative to the firm value (V). Different firms with same WACC and cash flow should have identical values.

Therefore it can be said that the only advantage of borrowing which is the cheap cost of borrowing as it is less risky to investors whereas financial leverage is the only disadvantage of borrowing. However, MM1 demonstrate that such an effect is cancel out exactly as cheap debts gives shareholders a higher rate of return but return is offset by the compensation given to shareholders resulting from higher leverage as shown below:

Advantages Disadvantages

Use of cheap dept

Increase in cost of equity

MM1 theory in the attempt to use cheaper debt is offset by the resulting increase in the cost of equity capital. [2] 

Non Taxed Economies

MM1 theory is consistent in countries such as Kuwait, Saudi Arabia and Bahrain among others [3] which follow the principle of "Shariah" (Islamic ruling). "Those who devour usury will not stand except as stands one whom the devil by his touch has driven to madness. Trade is like usury but Allah has permitted trade and forbidden usury. Allah will deprive usury of all blessing, but will give increase for deeds of charity, for he loves not any ungrateful sinner. O you, who believe, fear Allah and give up what remains of your demand for usury, if you are indeed believers". (Surah al Baqurah verse 275-280) [4] 

Such countries are resistant to the payment or acceptance of interest charges (riba) for the lending and acceptance of money. Tax and interest are considered to be a taboo as there significant difference about how a debt is structured and obtained for corporate financing in the Arab League. Edward (2000) found that 95% of the Islamic financial institutions follow the Islamic principle. Certain form of predetermination of profit or "mark up" is acceptable to "Sharia" as it is considered as a "capital gain" but not "interest".

Assuming other factors remaining constant such as risk, liquidity, maturity, agency cost, bankruptcy cost and information asymmetry cost to be equal there should not be a preference for debt over equity and vice versa in a non taxed economy which satisfy MM1 theory.

Modigliani and Miller (1963) (MM2)

Corporation Tax

MM1 theory had to be revised in order to implement tax (t) in the capital structure breaking down. The underlying problem is that dividend and interest are treated unsymmetrical in the corporate tax bill. Interest is not taxable at corporate level thus the after tax stream payable to stakeholders will affect the value of the firm and the choice of capital structure. Following the marginal tax benefit of debt financing, any additional unit of debt would decrease WACC and leave a higher after tax cash flow to equity holders resulting to a higher firm value.

Following MM2 theory, in a world with corporate tax, a firm should maximize its use of debt to benefit from the interest tax shield (td) [5] . Firms with debt will have a higher value than that of an unlevered firm by an amount equal to the marginal tax rate multiplied by the value of debt as illustrated below:

VU = VL + td

For the same level of operating income, using the tax shield benefit (1-t) of debt financing, WACC for a levered firm must be lower than that of an all equity firm. By the introduction of corporation tax and adjusting the tax benefit from debt, the following WACC formula can be derived from MM1 theory.

WACC = rA = rd (D/V)(1-t) + re (E/V)

Hence, unlike MM1 proposition, it can be found that in a market there are imperfections. The choice of capital structure and firm value differ accordingly to the extent to which they are affected by the imperfections.

The formula shows that the shareholders and debt holders are not the only ones to claim for firm's cash flows as tax represent a claim. As leverage increases, tax claim over the firm's cash flow decreases. However, bankruptcy cost is also a claim on cash flows whereby the value of bankruptcy claim increases with leverage. The following pie charts explain that if debt of a firm increases, the relatives value of the claims vary accordingly as illustrated below:

As leverage increases, tax is reduced because the corporation tax system carries a distortion under which the return to debt holders is tax deductible, whereas returns to shareholders are not. Thus the advantages of using debt increases as shown below:

Disadvantages

Increases cost of equity

Tax relief on interest

Cheap debts

Advantages

The original cheap debt advantage continues to be offset by the increase in the cost of equity when debt is used.

Corporate and Personal Tax

Using the arbitrage concept MM demonstrated that if the value of a similar asset is sold at different prices for a levered and unlevered firm then an investor can make an arbitrage profit (buying undervalue and selling overprice asset). An investor is taxed differently on his income from interest, dividend and capital gain. Equity holders are taxed twice both at corporate level and personal level whereas debt holders are taxed only at personal level. A rational investor would act differently on their choice of investment to avoid tax.

Following the cash flow stream accruing to equity holders with interest tax, corporate tax (rc) and dividend tax, the following equation can be used to represent the present value of a firm.

VL = VU + D{1- (1-rc)(1-re)}

(1-rd)

The second term on the left shows the taxation gain from debt that a firm would benefit.

MM showed that the value and cost of a firm is unalike with and without tax. Diagrammatically, it can be illustrated as follows:

Non Tax Firm

Cost of capital

re Cost of equity

rA WACC

rd Cost of debt

D/E

Tax Firm

Cost of capital

re Cost of equity

rA WACC

rd Cost of debt

D/E

The WACC of a taxed firm tend to decrease towards the cost of debt because of the existence of marginal tax benefit of debt financing which reduces cost of raising capital. The decreasing WACC shows that a firm should borrow as much as possible.

Being a rational investor or firm manager, there should always be a preference for debt over equity by decreasing tax liability and maximizing return. If the company uses share capital to raise finance then it will be foregoing the advantage of borrowing.

The advantage of borrowing as the present value of tax saving from interest payment is known as the tax shield. It is found that when corporation tax was introduced in the in the revised theory, the value of the geared and ungeared companies differs by the amount of tax shield.

Apart from tax there are other factors such as financial distress, agency cost and information asymmetry which are associated with the use of debt and influence the value of levered firm.

Static Trade off Theory

The trade off theory stipulates that there exist an optimal capital structure. When firms take decision about financial leverage, they must weigh the value enhancing or reducing effect on leverage by balancing the advantages and disadvantages of an additional unit of debt. Among the advantages include the interest tax shield of debt [6] which is unpaid at corporate level and disadvantages include the cost of financial distress [7] (PV).

Financial distress occurs when a firm has lower or negative earnings during economic slowdown. It includes cost such as:

Direct cost such as lawyer's fees, court fees and administrative expense that absorb a large part of the firm's value.

Indirect cost are non managerial actions impose by customers, suppliers and capital providers if the firm doesn't go into bankruptcy.

The cost incurred during the time interval for the bankruptcy cases to be settled as over time the value of the asset will be depreciated.

Financial distresses are all the administrative and legal cost that arises whenever the credit worthiness of a firm is in doubt which can reduce its market value. Hence the value of a levered firm will be as follows:

VL = VU + td - PV

The optimal capital structure is any point where the value enhancing effect completely offset the value reducing effect by increasing financial leverage. In other words it is the optimal point where the value of capital structure is maximized as shown below:

Market value of firm

Maximum Value of Firm

Cost of Financial Distress

PV of Interest Value of Levered Firm

Tax Shield

Value of

Unlevered Firm

D/E

Cost of Capital

Cost of Equity

WACC

Cost of Debt

Optimal Debt/ Equity Ratio D/E

From the above diagram it can be seen that as cost of equity is assumed to increase at an increasing rate to leverage, cost of debt will rise only after significant leverage has occurred. This occurs because the WACC of equity financing does not offset entirely the use of cheaper debt. Unlike the MM theory (1958) that argue that a firm can take as much debt as it wants, the trade off theory postulates that the optimal debt usage is any point where any additional would cause cost of financial distress to increase by an amount greater than the benefit of additional tax shield.

Agency cost theory

Jensen and Meckling (1976) found that the optimal capital structure will be determined by minimizing the cost that arises by firms' owners due to conflicts between debt holders and equity holders and between managers and equity holders. Agency cost arises due to the fact equity holders have limited liability while debt holder receive a fixed maximum return. When a firm is in financial distress, shareholders encourage management to expropriate fund from debt holders to equity holders. Debt with interest payments reduces the agency conflict between shareholders and mangers as when interest payment are due managers are stuck in legal procedures, thus they will operate in such a way that will maximize shareholders wealth. Hence managers stipulate the optimal capital structure when agency cost is minimized.

Pecking Order Theory

Pecking order theory is based on the asymmetric information problem (Myers and Majluf 1984). Asymmetric information arises due to the fact that managers are better informed in terms of the firms current earning and future growth opportunities than outsiders' investors. There is no optimal capital structure as debt ratios will change according to investment opportunities. Firms opt mostly for internal financing whenever possible and have a preference for debt over equity as it is less affected by information asymmetry (Peireson et al 2002). Internal funds can be raised without any cost and any disclosure of prior information. Managers will choose to issue debt whenever investors undervalue the firm and issue equity in periods of high market performance and vice versa. Hence the debt/ equity ratio is observed to have a direct relationship with market performance. Such a theory mostly lays emphasis on the cost of issue as it takes the lowest financing to finance investment decision and then moves towards the highest one. Thus it can be justify that highly profitable firms will generally tend to borrow less and aim to have a low leverage ratio because they don't need external finance. The theory further stipulates that if surplus cash generated cannot be reinvested, it can be used to pay-off debt rather than paying dividend on short terms or purchase back shares. In other words, it ensures a stable dividend policy rather than consistency in the gearing ratio, signifying that an optimal level of gearing is not a priority.

Empirical Evidence

Empirical studies have generated many attempts to explain the determinants of capital structure. Using the fourteen European communities, Gleason et al (2000) found that capital structure is influence by the legal environment, tax environment, economic system and technology capabilities. Based on an international basis it is found that the surrounding environment, macro economic conditions and firms' economic factors affect financing decisions.

Opler and Titman (1997) try to determine the relative importance of debt to equity choice by comparing firms in the US. In their study carried out in the period 1976-1993, they found that firms' behaviour could be explained by the static trade-off and pecking order theory to explain the choice of capital structure. Titman (2001) found that firms with low leverage and high level of profit will issue more debts which are in accordance to the tradeoff model. Furthermore, they confirm that there is a negative relationship between the market-to-book ratios and the debt to equity choice. This is due to the fact that as the probability of issuing debt to equity declines with the firm's market-to-book ratio, firms with high market-to-book value will have a high target ratios and vice versa.

A study done by Manos and Ah-hen using 24 nonfinancial listed firm for the period 1992-2000 in Mauritius found out that the determinants of capital structure are in favor of the pecking order theory that is firms prefer internal financing when available and for external financing there is a preference of debt over equity, thus rejecting the trade off theory. They also found that there is a preference for long term finance in the Mauritian capital market with respect to age, growth, risk and profitability.

Singh and Hamid (1992) selected 50 manufacturing firms quoted on the stock market from nine developing countries namely Mexico, India, Pakistan, Turkey, Korea, Thailand, Malaysia, Jordon and Zimbabwe. They found that the firms were relying heavily on external funds and new issue of shares to finance new asset. In the 1980's, Korea had 40% of equity in its capital structure, Jordan 50% and Turkey 60%. Such a result was unexpected as it goes against the pecking order theory which stipulates that firms should prefer internal source of finance as opposed to external ones and if investment requirements are greater than retained earnings, they should prefer debt and as a last resort issue equity to raise capital.

Based on a study of 800 non-financial firms in 7 emerging countries namely Argentina, Brazil, Indonesia, Malaysia, Mexico, South Korea and Thailand for the period 1980-1990, Schmukler and Vesperoni (2000) found that larger firms have a lower level of short-term debt, a higher lever of long-term debt and hold debt of higher maturity. Firms with higher level of profit are positively correlated with the level of internal financing thus holding shorter debt maturity and have a low leverage. Such finding is consistent with the pecking order hypothesis.

Theoretical arguments of tax sensibility for capital structure are very strong, Mac Kie Mason (1990); Trezevant (1992); Dhaliwal er al (1992); Shum (1996); Graham and Tacher (2006), found that there is a significant tax effect on the debt policy of firms. Firms with low corporation tax will have a lower amount of debt. , Hahn, Ofer, and Sarig (1992) find that increasing tax rates at corporate level make debts more attractive.

Graham (1998) in his paper found that corporate tax and personal tax has a significant importance and affects corporate financing decision. There exist a negative relationship between debt ratios and tax rates when taxes are measured with after-financing income because interest on debt are tax deductible at corporate level thus reducing the expected marginal tax rates, while Schulman et al. (1996) found that debt ratios with respect to the before financing tax rates are positively correlated across a sample of 51 countries. Firms with high income tax will shift to more debt in their capital structure in order to decrease the tax liability.

Instead of using just the past paid taxes, Givoly, et al. (1992) tested the effect of the Tax Reform Act (TRA) 1986 in respect to the change in leverage of the US firms. He used the support of basic theories of capital structure and found that firms decrease leverage whenever there is a drop in tax rate is greater with an effective tax rates. He found that the relation of debt use is positively correlated with the marginal tax rate and firms with statutory tax rate greater than marginal tax rate will issue more debts with the expectation of to decrease tax bill.

DeAngelo and Masulis (1980) worked on the effect of non-debts sources of tax shield and found that the tax shield benefit of debt can be derived only after other tax shield benefit such as depreciation, losses and investment tax credit has been exhausted. Hence the tax shield benefit of debt is moderated by the presence of non-debt tax shield benefits.

Booth, et al (2001) tested whether capital structure theory is in line across countries and found as the previous empirical researcher that across countries debt ratio are negatively related to tax rates. Their attributes were based on the possibility of higher profitability rather than emphasizing on the debt tax shield potential. However Antoniou,et al (2002) used a panel of data from Britain, France and German and found that capital structure decision is based on a number of variables than tax.

Using the non debt tax shield (NDTS) effect on debt policy, Givolry at al (1992) and Graham (1996) found that there is a negative relationship between the level of a firm's debt and the amount of NDTS [8] . Later on, Bathala et al (1994) found a positive relationship between a firm's level of debt and the amount of NDTS which is according to the traditional theories. Thus the positive relationship suggest that NDTS affect debts, that is the higher is NDTS, the higher will be the value of the firm.

Draper and Huizinga (2001) analyzed the corporate tax rate on the cost of capital and investment to determine the optimal capital structure of firms located in Netherlands. In this paper they found that a reduction in corporate tax rate reduces the cost of capital and that corporate tax has a direct effect on profit. Thus a decrease in corporate tax rate has either a positive, negative or neutral effect on the on the marginal incentive to invest if capital cost is less than fully, more than fully or fully deductible from corporate taxable income. In Netherland, since capital cost is less than fully deductible from corporate taxation, a decrease in corporate tax rate will increase investment. However, an increase in corporate tax will discourage new firms to invest or invest elsewhere.

Feltenstein and Shah (1993) used an equilibrium model to address the issue of investment tax credit in Pakistan. Firstly, they wanted to estimate the effect of the increasing investment tax credit from 15% to 30% and found that there was a significant increase in inflation rate. Secondly, they retained the original investment tax credit and reduced the corporate tax rate and found that capital formation increased.

Limited studies are done on the effect of personal tax on the choice of capital structure. Givoly et al (1992) found a negative relationship on firms leverage while Graham (1996) observe that personal tax of debt and equity has no effect on debt. Recently in 2008, Huizinga, Laeven and Nicodeme found a direct relationship between financial leverage, local tax and tax differential across countries of European multinationals'.

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