Market Value of the Firm Finance Essay

The corporate market value is the value of a company as an enterprise and it derives this value from the underlying equity share. In this sense, business or corporate valuation is aboutA measuring the continuingA value of aA company's business. An organization employs different types of funding to run a business smoothly. This is what capital structure is all about, that is, the composition of different types of financing employed by a firm to acquire resources necessary for its operations and growth and it primarily comprises of long-term debt, preferred stock, and net worth. Most of the companies raises fund by equity or debt. So this strategic decision is very important as it will have an impact on the market value of the firm. The corporate value of a company is of great significance when it is on the stock market as is has a direct impact on the price of the shares on sale. Higher market value will imply a higher share price which will procure many advantages to the company. First, it shows that the company is doing well and will give potential buyers a sense of confidence in the company. They will feel more confident in investing in the company instead of elsewhere. Second, the higher price of the shares will give the company a bigger capital for funding. An increase in funding will give the company the possibility to aim bigger and achieve much more in terms of profitability. In the paragraph above, I explained the relationship between equity financing and market value but, as mentioned previously, capital is about funding by equity and/or debt. And financing with debt has also its advantages, namely in terms of the tax shield arguments. Tax shield is a reduction in taxable income for a company gained through claiming acceptable deductions such as interest, or depreciation. These deductions decrease the companies' taxable income for a given year or postpone income taxes into future years. Tax shields differ from country to country, and their advantages will depend on the companies' overall tax rate and cash flows for that given tax year.

1.1 Tax Shields

AA tax shieldA is a legal way of decreasing income with the purpose of sheltering it fromA taxation. In that sense aA taxA shield is the same as aA tax deduction, except that aA taxA shield can also include rescheduling of income to future years. Any firm is entitled to use a tax shield. For example, donations to charity can be employed as a tax shield, as can business losses, interest on many business loans, andA depreciation. There are two types of tax shields that may be considered as a legal method to reduce the tax burden, namely debt tax shields (or interest tax shields) and non-debt tax shields. Debt tax shield is a reduction inA tax liabilityA coming from the ability toA deductA interest payments from one'sA taxable income. An interest tax shield may encourage a company toA financeA a project throughA debtA becauseA dividendsA paid onA stockA issues are never deductible. Companies are able to use debt to their advantage. When a company needs to raise capital, they have two options. They can sell stocks and shares or take on debt. Selling stocks and shares means they need to pay dividends to their shareholders. Taking on debt is advantageous because the company can write off the interest payments on their income taxes. Debt in this instance is less risky and more profitable than selling equity. DeAngelo and Masulis (1980) were among the original ones to point to the significance of non-debt tax shields, mainly tax credits and depreciation, for capital structure relevance. There is also evidence, principally in the accounting literature that U.S. companies have been taking a host of other or newer tax shields as shown through examples in Bankman (1999), Desai (2003), Manzon and Plesko (2002), and Mills, Newberry and Trautman (2002). Non-debt tax shelters are a very crucial aspect of tax shields as they procure the same advantages as debt tax shield but they do not generate the same bad effects, like financial instability, on economic activity.

1.2 Problem Statement

Debt tax shield is a very important factor as it can be detrimental to companies which choose to ignore it. Debt tax shield can be used as a strategic tool to reduce voluntarily earnings before tax so that the tax expense too decreases. In other words, it encourages the use of debt financing which can have both a positive and a negative impact on the market value of the company. So debt tax shield can be said to have somehow a connection with the corporate valuation process of firm. This connection is what this study is going to be based on and how the calculation of market value is going to be affected by the debt tax shield factor.

1.3 Objectives of Study

Capital structure is a combination of debt and equity. As it was pointed out by Modigliani and Miller, a primary advantage of debt is the tax shield effect. The objective of this research is to evaluate and assess the tax shield argument in the corporate capital structure decisions, particularly with the listed firms of Mauritius. The following aims can be attached to this study: Understand the importance of the market value of a firm. Assess the significance of the tax shield argument. To distinguish between debt and non-debt tax shields. To identify the effects of tax shields on the market value of the firm.

1.4 Significance of Study

The listed firms in Mauritius will find this study important in such a way that these companies can design their future strategies to use debt tax shield effectively without causing any negative impact on their market value. The study will give the opportunity to these listed firms to be able to see the connection of various variables like debt tax shield, debt, or profitability on their market value. This research will impose companies to embark upon the right 'management' of debt tax shield to help eliminate its negative impacts on market value. This dissertation will be of paramount importance to anyone looking for a clear explanation on the tax shield argument and its impact on the market value of a company.

1.5 Format of Study

1.5 1 Chapter 1 - Introduction

This chapter gives an overview of what the dissertation will consist of. The topic has been identified and the research objectives of the study have been set up. In addition, the reason why the study of the tax shields argument is worthwhile to have been pointed out.

1.5.2 Chapter 2 - Literature Review

The literature review shall begin with an introduction followed by a brief overview on capital structure decisions. There shall be discussions on the different tax shields associated with corporate capital structure decisions. This chapter will consist of two parts, one being the theoretical review which summarises all the previous literature reviews done on the topic. The second part is the empirical evidence which is about all the information acquired by the means of previous researches and analysis done on the subject by authors.

1.5.3 Chapter 3 - Research Methodology

This chapter provides an illustration of how the study has been conducted and the precautions taken to ensure reliable and valid results. Moreover, the hypotheses to be tested will be formulated in this chapter.

1.5.4 Chapter 4 - Analysis and Findings

Regression analysis will display the findings and shall be presented and analysed with reference to the literature review. The findings shall be discussed and those data that are in par or contradictory shall be highlighted to be further discussed.

1.5.5 Chapter 5 - Conclusion

The chapter has given an overview of what the whole dissertation shall comprise and what is to be investigated. The conclusion of this study shall be pointed out along with the recommendations that are deemed to be the solution to the problems found out. The chapter shall provide further insight on the topic that has been investigated.

2.0 Literature Review

2.1 Market Value of the Firm

Valuation theories have been comprehensively studied by various accounting researchers. Although, empirically there has been not a clear-cut winner, it appears that this area of examination is going in the path of performance based examinations to evaluate valuation. Torrez, Campus, Al-Jafari, and Juma'h (2006) used Arbitrage Pricing Models (APM) and Capital Asset Pricing Model (CAPM) as methods to estimate the value of companies. Benninga and Sarig (1997) recommended using more than just only one valuation method to evaluate the corporate value. It was advised to utilise more than one technique because there is a great uncertainty in relation to estimation of corporate value as it implicates predicting future returns of the firm, and if the various techniques give similar outcomes it implies that the estimation of corporate value is sensible. On the other hand, Kemsley and Nissim (2002) found that the value of the company is a strong, constructive function of debt, and there have been similar studies on this relationship. One worth pointing out is the study done by Sharma (2006) which suggested a direct correlation between the value of firms and financial leverage. So the market value of a firm is also somehow connected to the firm's capital structure. Capital structure is mostly defined as the particular blend of debt and equity that a business uses to finance its activities. An optimal capital structure will produce the greatest income to the shareholders without adding supplementary cost to them and, at the same time, will increase the value of the corresponding company.

2.2 Tax Benefits Associated with Debt

In 1963, the authors acknowledged the effect of taxes on corporate capital structure. Modigliani and Miller's (1963) Proposition-II tried to give an answer to the problem of why when the debt ratio was boosted there was an increase in rate of return that resulted. It specified that the increase in expected rate of return spawned by financing with debt is accurately counterbalanced by the risk acquired, despite the consequences of the choice of financing mix. The selection of capital structure became so important as it will have a significant impact on the market value of the company. The most important motive that prompts companies to increase debts is owing to the tax benefits that arise from the tax discounts caused by making interest payments on debt. In considering the corporate income tax, they explored the question of the tax benefits generated by the use of debt capital as a source of funding such that interest payments, considered as an expense, are deducted from the calculation of taxable income. Thus, the value to be paid on taxes and increasing the free cash flow of the company is reduced. The fact that tax can be deducted on interest payments is considered as a major advantage of debt, and this tax deductibility on companies' interest payments supports the use of debt. As a result, by using debt, forecasted tax liability of companies could be subtracted and thus amplify its after-tax cash flow, provoking more profitable commerce to exploit the greater level of debt for the interest of augmenting their debt tax shield. Using debt decreases a firm's expected tax liability and increases its after-tax cash flow, making profitable firms employ more debt to increase the value of their debt tax shield. However, Taggart (1985) contends that corporate debt enjoys a net tax advantage when corporate tax rates exceed marginal personal tax rates. This violates the earlier Modigliani- Miller conclusion regarding corporate income tax, making corporate tax deductions at least partially offset by additional personal tax liabilities of the acquiring debt holders. Miller (1977) concludes that personal income taxes paid by investors in corporate debt just offset the corporate tax shield provided that the firm pays the full statutory tax rate. Green, Murinde and Suppakitjarak (2002) examined that tax policy has a vital impact on the capital structure choices of companies. Corporate taxes permit companies to remove interest on debt in calculating taxable profits. This recommends that tax benefits gained from debt would direct companies to be entirely financed through debt. This advantage is generated as, like mentioned before, the interest payments related with debt are tax deductible and while payments connected with equity, like for example dividends, are not tax deductible. Consequently, this tax effect supports debt use by the company, as more debt raises the holders' after tax proceeds (Modigliani and Miller, 1963; Miller, 1977). MacKie-Mason (1990) examined the tax consequence on corporate financing choices and offered proof of significant tax effect on the option between equity and debt. He ended by adding that alterations in the quantity of tax paid on a supplementary unit of income for any corporation should have an impact on financing decisions. Graham (1999) ended that on the whole, taxes do influence corporate financial choices, but the degree of the consequence is generally "not large". Miller (1977) and Myers (2001) argue that being the supply of debt for all the firms' increases, investors with better tax brackets have to be lured to take hold of corporate debt and to gain more of their revenue in the shape of interest instead of any profits on the disposition of capital assets. Interest rates climb as to a greater extent debt is issued, so firms face augmenting charges associated with debt compared to equity-related expenses. The tax advantages resulting from the issuance of more debt may be counteracted by the significant tax on interest income. Eventually it may be that it is the trade-off that concludes the final impact of taxes on the use of debt (Miller, 1977; Myers, 2001). Myers and Majloof (1984) examined the behaviour of corporate financing and argued that bankruptcy cost cannot be disregarded and the capital structure is trade-off between corporate tax benefit and bankruptcy cost, named as trade-off theory. It forecasts that a desirable objective debt percentage is to create the supreme value of the company. The tax trade-off model forecasts that profitable companies will make use of additional debt given that they are further prone to have a greater tax weight and little bankruptcy risk. Followers of the trade-off theory believe that debt-equity financing decision is a trade-off between interest tax shield and the cost of financial distress. The trade-off theory demonstrated that the companies should amplify their debt level until the occurrence of agency costs and bankruptcy costs from debt are simply indemnifying its tax gains, which is called the optimal level. And according to this trade-off theory, value-maximising organisations choose the level of debt by balancing tax benefits of debt against the cost associated with debt such as bankruptcy and agency costs (Gwatidzo and Ojah, 2009). Baxter (1967) and Altman (1984) argued that firms attain optimal capital structure- where benefits from tax shield equalled the cost of financial distress. The company's tax benefit from leverage is the present value of tax discounts generated by paying interest which are tax deductible on leverage in place of dividend compensations made to investors. The present value in general is obtained from the stage in which the risk related with the tax benefit is the equivalent of the risk of leverage that engenders the tax benefits. Nonetheless, the impact of interest tax benefit is based on the constitution of the tax system put into operation by every nation. Research undertook by Adedeji (1998) and Ashton (1989) disclosed that "the tax system in UK does not encourage firms to use debt as much the classical tax system does in US. Compared with the UK tax regimen, the US tax system allows firms to sustain a loss for the year to carry-back or carry-forward such losses".

2.3 Tax Benefits Associated with Non-Debt Factors

In addition, the allocation of debt would be altered by the presence of alternate non-debt tax benefits like, for example, development expenses, depreciation, investment tax credit and allowances for research. Debt interest tax shields are not the sole technique of minimising corporate tax weights. The existence of non-debt tax shields offers a substitute (and most probably less expensive) way of minimising income taxes and could be used to alleviate the advantage of debt tax shields (Cloyd, 1997). Without a doubt, there is a variety of non-debt tax shields, like for example investment tax credits and accelerated depreciation (Allen and Mizuno, 1989). Non-debt tax shield is described as a percentage of total yearly depreciation to total assets. There are various reasons for why do companies would rather choose alternative tax shields to debt. The first and foremost reason is that many tax shields are not as expensive as debt, because debt generally requires expensive interest payments. Various tax shields do not demand any supplementary expenses for the company. Another factor that favours non-debt tax shield to be rather considered is the cost to the company linked with debt covenants. These debt covenants are expected to create greater transaction costs for some companies. Lastly, tax shields usually take advantage of the provisions in the accounting rules that permit the company to decrease taxes without having an impact on the income statement. DeAnglo and Masulis (1980) explained that "firms with tax deductions for depreciation and investment tax credits can consider these deductions as a substitute for the tax shield. They concluded that the positive tax shield alternate suggests that the anticipated marginal corporate tax advantage declined as leverage is added to the capital structure". Given that the cumulative tax discounts from an additional unit of debt declined with augmenting non-debt tax discounts, therefore greater leverage will be further expensive for a company with elevated level of non-debt tax discount. Subsequently, it would have an impact on the actions of managers to increase not as much of debt when the firm already utilized a significant quantity of non-debt tax discount. From this point, it was disclosed that there is an adverse correlation between debt and non-debt tax discount. Debt is thus more expensive for firms with a high level of non-debt tax shield because the marginal tax discounts from an extra unit of debt reduces with augmenting non-debt tax benefits. Bradley, Jarrell and Kim (1984) were in the midst of the initial ones to experiment for the tax effects put forward by DeAngelo and Masulis (1980). They did a regression on company-specific debt-to-value ratios on non-debt tax shields and they discovered that debt is positively correlated to non-debt tax shields, on the contrary to the forecast in De Angelo and Masulis (1980). Bradley et al. (1984) make use of depreciation and investment tax credits, research and development, and advertising expenses as their alternatives for non-debt tax shield. As Graham (2003) draws attention to, if a company invests greatly and takes loans to invest, an optimistic relation between such alternatives for non-debt tax shield and debt may result. In recent times, Shivdasani and Stefanescue (2010) demonstrated that pension assets and liabilities also operate as tax shields and pension contributions are about a third of those from interest payments.

2.4 Empirical Evidence

According to the theoretical point of view, the increased use of debt will result in an augmentation of income as firms will pay tax less. But this tax benefit is traded off against the possibility of sustaining cost like agency costs or bankruptcy costs. Now let's turn to the empirical evidence with regard to a variety of tax-related features of capital structure decisions. What we can take note on previous researches undertaken is that there is a small amount of empirical investigations that may be regarded as to be direct experiments of the tax shield model of debt. Givoly, et al. (1992) examined the impact of the TRA (Tax Reform Act) of 1986 on the alterations in leverage in US companies. They experimented and found solutions that maintained the tax shield based hypothesises of capital structure decisions. Kemsley and Nissim (2002) used cross-sectional regressions in their study to approximately calculate the worth of the debt tax shield. They distinguished that debt is possibly related with the value of procedures along non-tax aspects and used reverse regressions to moderate the impact of this relationship. After that, they found that the value of the company is a strong, constructive function of debt. Additionally, they found the approximate worth of the net debt tax shield is undeniably linked to time-series deviation in constitutional tax rates and it is without fail linked to cross-sectional deviation in approximated company level marginal tax rates. Moreover, the outcomes are strong to the utilization of interest expense to compute debt. Singh and Hamid (1992) utilize information from nine developing countries from multiple sites all around the globe. They discovered that differences in tax and legal factors and other institutional aspects (like degree of development of financial markets or accounting practices) are the causes of all the dissimilarities in the scales of the determinants of capital structure. Their facts indirectly provided a backing for the tax model in the capital structure decisions. Booth, et al. (2001) considered if capital structure theory is moveable to different countries which have diverse institutional constitutions. They discovered that debt ratios are adversely connected to taxation. They accredited their apparently peculiar verdict to the likelihood that the tax rate measure utilized in their research is covering for profitability instead of the tax shield, which meant that the higher the tax rate the greater the profitability. Antoniou, et al. (2002) utilize archive data from Germany, Britain, and France and got mixed outcome, which showed that institutional planning and national customs have a say in capital structure decisions. Frank and Goyal (2004) carried out experiments and put forward that their evidence is reliable with the trade-off theory; however they did not find backing for market timing theories or the pecking order. Kim and Wu (1988) as well as Mandelker and Rhee (1984) provided empirical evidence that leads to a trade-off between debt tax shields and investment. Barakat, M.H. and Rao, R.P. (2003) found that companies working in Arab states use much more debt when these states have a corporate tax system in position compared to those working in countries where there is no proper corporate tax system. In a current analysis, Cespedes et.al (2009) gave explanation to the actions of companies in Latin America enveloping seven countries. They encountered that ownership oriented companies favored equity financing because of higher bankruptcy costs and inferior tax shields. Afza T. and Hussain A. (2011) provided evidence that the companies of the automobile segments with big asset structure have a preference for debt financing to gain with the advantages of tax shield. Boquist and Moore's (1984) results did not back the tax shield theory at the company level but, on the other hand, they did discover feeble proof in support of the hypothesis at the industry level. Bartholdy and Mateus (2008) took a look at small and medium sized firms in West European which are, nonetheless, just engaged in their domestic markets and they stated that there are economically imperative and significant outcomes of local taxes on debt ratios. Desai et al. (2004a) as well as Altshuler and Grubert (2003) have been the initial ones to observe balance sheet information of foreign associates of multinational companies. Both works empirically corroborate a considerable effect of local tax rates on associate leverage of multinationals based in the U.S. Whilst Altshuler and Grubert (2003) utilize statutory tax rates in their experiments, Desai et al. (2004a) make use of median effective tax rates described as foreign income taxes settled over foreign pre-tax profits for every nation. Breaking off the totality of leverage into internal and external debt, Altshuler et al. (2003) only discovered considerable tax impacts on internal debt ratios. Whereas Desai et al. (2004a) stated considerable effects for both sorts of debt. Mintz and Weichenrieder (2005) examined the effect that host-country taxes have on the capital structures of associates of German multinationals, and they also discovered a positive tax effect on total debt. In addition, they discovered greater tax elasticity if an auxiliary is totally-possessed by the German parent firm. Additionally, Mintz and Weichenrieder (2005) provided explanation for various sources of debt. They could only corroborate a considerable favourable tax effect on internal debt, whilst they were not capable to discover an arithmetically significant tax effect of the home country taxes on external debt funding of overseas associates of German parent firms. Büttner et al. (2006) made use the similar information set but, compared to Mintz and Weichenrieder (2005), do take into consideration the cross-section tax variations and do not completely manage for unmonitored country-specific consequences. Büttner et al. (2008) demonstrates that during the previous decades, the number of countries that put a ceiling on the tax deductibility of interest payments related with debt financing has considerably augmented. Recent studies examine the consequences of thin-capitalization regulations on debt financing. Consequently, Büttner et al. (2008) investigate the efficiency of thin-capitalization regulations in OECD and European countries on financing with debt of subsidiaries of German multinationals. The end results put forward that thin-capitalization regulations cause a decrease in internal debt and efficiently get rid of the reason to utilize such loans for tax planning. When utilizing the tax variation between various host countries of a multinational group, they discovered a positive impact of host-country taxes on both external as well as internal debt. Ruf (2008) also reassesses the effect of host-country taxes on financial choices of associates held by German parent corporations. He makes use of various explanations of the financial leverage and discovers that the positive effect of host-country taxes on debt financing is mostly an outcome of the scarcity of retained earnings at high-tax places in place of an incentive to make use of supplementary debt as a tax shield. In addition, he presents empirical evidence that an elevated corporate income tax rate augments the likelihood of multinationals setting up a finance firm in the respective country which then bears considerable quantities of debt. The empirical evidence concerning non-debt tax shields has given in miscellaneous outcomes. We can take the example of Bennett and Donnelly (1993), Saa-Requejo (1996), Wiwattanakantang (1999), De Miguel and Pindado (2001), Ozkan (2001) and Ngugi (2008) who have authenticated the forecast of DeAngelo and Masulis (1980) that non-debt tax shields are a replacement for debt. Titman and Wessels (1988) too did not find any proof to support the association between leverage and non-debt tax shields. On the other hand, Bradley et al. (1984), Barclay, Smith and Watts (1995) and Boyle and Eckhold (1997) gave proof recommending that non-debt tax shields have a positive effect on a company's leverage. Huang and Song (2006) carried out an empirical research in China and discovered that non-debt tax shields are positively linked to company leverage, which is unfailing with the result of Bradley et al. (1984). Chang et al. (2009) also corroborated the positive link between non-debt tax shields and leverage for Compustat- listed non-financial companies. Quite the opposite, Scott (1977) and Moore (1986) argue that companies with considerable non-debt tax shields must also have significant collateral assets which can be utilised to secure debt. From a theoretical point of view, it has been argued above that a secured debt carries less risk than an unsecured debt. Therefore, still theoretically, one could also argue for a positive link between non-debt shield and leverage. But in fact, the empirical tests of the non-debt tax shield effect on debt policy again are found to be mixed. For example, Shenoy and Koch (1996) found a negative connection between non-debt tax shield and leverage, while Gardner and Trcinka (1992) find a positive one. This disagreement is not astonishing because of two major causes presented by Barclay and Smith (2005). First of all, companies with high non-debt tax shields have greater quantity of tangible assets in their balance sheet. And this offers an amplified probability to mount up more debt. For that reason, non-debt tax shields might not only be a alternative for low taxes, but somewhat a proxy for low incurring costs related with debt. Secondly, companies with tax loss carry forwards are over and over again in financial distress. Therefore, the market value of equity for such companies is worn down in that way rising the debt ratio. Consequently, it is not obvious whether tax loss carry forwards are a dependable alternative for non-debt tax shields. Graham and Tucker (2006) utilise a matched pairs approach to recognize tax effects on the capital structure selection. They measured up to the use of debt financing of companies which are contracted in aggressive tax preparation and of companies which do not apply these arrangements. They discovered proof that non-debt tax shields engendered by the tax shelters work as an alternate for debt. Their sample, which consisted of 76 companies, the 38 companies utilizing tax shelters obtain debt ratios that are more than 5 percent inferior than those of other companies which are not engaged in that kind of tax preparation. SayA„A±lgan, Karabacak, and Küçükkocaoglu (2006) carried out an empirical experimenting to analyze the impact of company specific determinants on the capital structure decisions of Turkish companies, using dynamic panel data methodology. Their sample covered 123 Turkish manufacturing companies which are listed on the ISE (Istanbul Stock Exchange) and their analysis was based on year-end inspections of ten successive years running from 1993-2002. In their study, they used the panel data methodology and non-debt tax shields was one of the six variables which were analyzed as the company specific characteristics of the corporate capital structure. The empirical results on the capital structure determinants of the Turkish companies revealed that non-debt tax shields are negatively related with the leverage ratio. A few authors, like for example Givoly, et al. (1992) or Graham (1996), found a negative link between the company's level of debt and the amount of non-debt tax shield, supporting DeAngelo and Masulis' (1980) substitutability hypothesis. And many others, like Bradley, et al. (1984) and Bathala, et al. (1994), found a positive link between the company's level of debt and the amount of non-debt tax shield. A positive connection disagrees with the conventional substitutability argument between debt tax shield and non-debt tax shield. Harris and Raviv (1991) speculated that leverage is positively linked to non-debt tax shields. The positive connection is argued away by suggesting that non-debt tax shield is an instrumental variable for debt collateral, that is, non-debt tax shield is taking up the collateral effect of debt, which thus means that the higher the non-debt tax shield, the higher the collateral value of assets. And in connection with the consequence of personal taxes, only a restricted quantity of analysis was encountered in many review of the literature. Among the few studies encountered, Givoly, et al. (1992) discovered that personal taxes have a negative impact on the company's leverage while Graham (1996) observed that the relative taxation of equity and debt at the personal level has no impact on debt. Chaplinsky and Niehaus (1993) used the percentage of depreciation cost plus investment tax credits to total assets to calculate non-debt tax shields and the experiment prove that leverage is negatively linked with non-debt tax shields. Thomas W. Downs (1993), in his study, examined whether financing with debt is crowded out by depreciation tax shields. This crowding-out theory is asserted on the supposition that as non-debt tax deductions augment, the incentive to rely on debt tax shields reduces. His analysis computed the non-debt tax shields as the discounted value of expected tax depreciation deductions. When the discounted depreciation tax shield is scaled by either discounted income before tax or total assets, and subsequently the ratio is related to market based leverage measures, the estimates indicate that crowding-out does not occur; the estimated coefficients are almost always positive and statistically significant. The results showed that companies with relatively high depreciation tax shields also tend to have high leverage ratios. The explanation for this is that companies garnering a substantial proportion of cash flow from depreciation have substantial collateral assets, which are financed at a lower interest rate and possess a greater debt capacity, and the greater debt capacity is exploited as companies maintain a capital structure with significantly more debt than otherwise.

2.5 Conclusion

By adding more debt, a company amplifies its value through the market's awareness of lower bankruptcy costs and greater tax benefits. But any best possible capital structure at a top to bottom debt financing is obviously unsuited with monitored capital structures, so some results initiated a substantial investigation attempt to recognize the costs of financing with debt that would counterbalance the corporate tax benefit. Robichek and Myers (1965) argue that the detrimental result of bankruptcy costs on debt will prevent companies from having the yearning to acquire more debt. The general result is that the mixture of debt related costs (such as agency costs and bankruptcy costs) and the tax gain of debt creates the most favourable capital structure which will not be entirely debt funded, as the tax benefit is traded off against the possibility of sustaining the costs.

3.0 Data and Methodology

According to John W. Best (2002) research method may be defined as "systematic and objective analysis and recording of controlled observations that may lead to development of organizations, principles and possibility ultimate control events". This chapter describes the research methodology used in the present study. Firstly, we describe the rationale of the methodology, which justifies the choice of research approach and research strategy adopted to assess the impact of tax shields on the market value of a firm. Next, the data collection techniques are explored with a view to explain the types of data to be used. Finally, the chapter stresses on the measures adopted to ensure validity and reliability of data gathered.

3.1 Research Objectives

The aim of this study is to know whether the market value of companies are affected by the tax benefits associated with debt factors and if so, to what extent, and how it can be a used as a tool for better future strategic decisions. This study aims at better helping the companies in Mauritius, more specific the listed firms in the official market, to better understand the theory and impact of tax shields. Find the best model to estimate debt tax shield. Collect all the data required from the annual reports of the listed firms in Mauritius. Analyse how far average profitability and debt can affect the corporate market value. Analyse the impact of debt tax shield on the market value of a firm.

3.2 Research Hypothesis

As a general rule, to identify the truth of a given hypothesis, some data or evidence is gathered with a supposition that this evidence set was engendered from the hypothesis. Hypothesis testing is an arithmetic decision making process with regard to an uncertain hypothesis. The aim is to test the statistics to determine the possibility that a given hypothesis is accurate. The hypothesis testing will reveal the correlation between the variables and through this statistical method, a more concise and lucid evaluation can be obtained.

First hypothesis:

Ho: There is no significant relationship between the market value of the firm and operating income. H1: There is a positive relationship between the market value of the firm and operating income.

Second hypothesis:

Ho: There is no significant relationship between the market value of the firm and level of debt. H1: There is significant relationship between the market value of the firm and level of debt.

Third hypothesis:

Ho: There is no significant relationship between the market value of the firm and total assets. H1: There is no significant relationship between the market value of the firm and total assets.

Fourth hypothesis:

Ho: Debt tax shield has no impact on the market value of the firm. H1: Debt tax shield has an impact on the market value of the firm.

3.3 Data Collection

The purpose of gathering information is to meet objectives. According to Phipps (2001), data gathering must be easy, meaningful, and clearly related to the current study. Data collection can be of primary and/or of secondary type. Secondary data have been used for the study.

3.3.1 Secondary Data

Often the information that an organization needs to solve its problem already exists in the form of secondary data, or data that have been collected for some purpose other than the question at hand (Churchill, 1996). Housden (2003) further adds to it stating that secondary data is also called desk research because it is usually accessible from a desk via intranet or online or in hard copy.

3.3.2 Advantages of Secondary Data

Secondary dataA can assist or conduct the researcher in looking for or deciding on a better research problem; for this reason a duplication of a parallel problem may be made using a different locale or a different set of respondents. Secondary data can also ensure that there is no duplication of an investigation already made as it may also serve as a basis of comparison. It also helps in the formulation of specific questions, assumptions, framework, methods, sampling techniques, implications, and conclusions. Secondary data may also be used to verify the researcher's own findings and may save money and time if on target.

3.4 Sample Data

The sample of companies used in this dissertation was drawn from the Stock Exchange of Mauritius since it included the lists of all listed companies in Mauritius. Twenty listed firms have been included for which the financial statements have been analysed for the period of 2007-2011. The companies that have been chosen to be included to this study needs to have the following requirements, that is, it must have filed accounts for the period of the study and that it does not have inconsistent financial data for more than four accounting periods. For that reason, a number of companies have been rejected for which data was not available for the whole period, either because they have missing values for more than four years or were newly formed. Since all the listed firms in this sample have the same financial year, this eliminates the twisting impact of dissimilar reporting periods and seasonality patterns.

3.5 Regression Model

Following Modigliani and Miller's equations to value debt tax shield, I have come to two distinct equations that forms the foundation for two opposite approaches for observing the value of debt tax shields. These approaches are the forward and reverse approach. For this study, we will be taking these approaches into consideration only for mathematical purposes as each approach has its advantages and drawbacks and each of these drawbacks could cause errors that could bias the estimates. So using both equations from the forward and reverse approach, we can now develop a linear empirical equation to better analyse the value of debt tax shield. This empirical equation that we are going to estimate is: In the equation, stands for the market value of the company, determined as the book values of debt added with the market value of equity. FOI symbolizes average operating income over the subsequent five years. TA represents total assets and D represents debt. In the model above, I followed Fama and French (1998) by deflating all the variables in the equation by total assets (TA), and also like Fama and French (1998), I have not deflated the intercept. By the use of an undeflated intercept basically switches the variables into ratios.

3.6 Variables

Having already instituted the foundation of the theoretical point of view of this study, which is also relevant to the way to which the evidence was brought together will be considered, it is now essential to reflect upon how the evidences will be gathered to back the arguments that were put forward in this dissertation. In this model, there are four main variables that each are linked to one another. These are the market value of the firm (VL), Total Assets (TA), Average Operating Income (FOI), and debt (D). The average value of each item was considered for the purpose of ratio computation and analysis.

3.6.1 Market Value of Firm

We must start with the Modigliani and Miller's stylised setting in which there are no personal tax effect, no financial distress costs form debt and only one constant corporate tax rate. So given this setting, we can use the following tax adjusted valuation model to calculate market value of the company: In the above equation, stands for the market value of the company which equals to the market value of debt added to the market value of equity. D symbolizes the market value of debt, stands for the market value of the listed company, and t stands for the tax advantage from a dollar of debt. Thus, here is used as an estimate for debt tax shield. In this model, the market value of a firm is the dependant variable, so I will put forward the impact that the independent variables will have on the market value of its corresponding companies.

3.6.2 Total Assets (TA)

Total assets comprises of all assets of a firm. An asset may be described as any items of ownership which can be converted into cash. The total assets data figures were all collected from each of the companies' balance sheets obtained from their respective annual reports. Most of the researches done to find the connection between total assets and market value of firm showed that they have a positive relationship. Market value of a firm and total assets reacts symmetrically to the changes in one another. For example, an increase in total assets would result in a consequent increase in the market value of the company. But there's also the possibility that an increase in debt may increase total assets but also decrease market value due to the higher risk of financial distress.

3.6.3 Average Operating Income (FOI)

In finance and accounting, operating income or earnings before interest and tax (EBIT) is the company's measure of profitability that excludes income tax expenses and interest. I measured FOI as the average operating income for the last five years starting from 2007 to 2011. Requiring five years of data permits us to obtain growth trends in operating income that we could not analyse by minimally using single-period-ahead operating earnings. The relationship between operating income and market value has been quite unanimous as the majority asserted that there is a positive link between operating income and market value due to the fact that increases in operating profit would result in an increase in the share price of the company and therefore an increase in the market value of the company.

3.6.4 Debt (D)

In this equation, I measured debt by excluding operating liabilities, which characteristically do not engender explicit tax-deductible interest expense. By removing operating liabilities from our measurement of D (and consequently), it permits me to uphold the MM relationship. In the model that I have chosen, the debt variable will be used as a proxy for debt tax shield. Debt's effect on market value will give us an estimate of the impact of debt tax shield on market value of the company. The relationship between debt and market value has been subject to many debates. Many researchers asserted that there is a negative relationship between debt and market value due to the fact that an increase in debt would automatically mean a decrease in market value as explained earlier and it would also result in a decrease in profits after tax and therefore a fall in the share price. But some researchers provide proof that debt may also have a positive link with market value as an increase in debt would result in an increase in earnings per share (EPS), which would cause an increase in the market value of the firm.

3.7 Limitation of Study

On the whole, the research work proved to be a very enriching experience, however there were some limitations worth pointing out. In the model that is being used for this dissertation, the variables represent ratios, so there also the possibility of biasness. To some degree, FOI/TA is a defective control for market value of equity over total assets () and is correlated to D/TA. So this bias will be negative.

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