Chapter 15 Debt and Taxes
15.1 The Interest Tax Deduction
Consider Safeway, Inc. which had earnings before interest and taxes of approximately
$1.85 billion in 2008, and interest expenses of about $350 million. Safeway’s marginal
corporate tax rate was 35%.
Safeway’s net income in 2008 was lower with leverage than it would have been without
leverage.
Safeway’s debt obligations reduced the value of its equity. But, the total amount
available to all investors was higher with leverage.
Interest Tax Shield
The reduction in taxes paid due to the tax deductibility of interest
In Safeway’s case, the gain is equal to the reduction in taxes with leverage:
$648 million − $525 million = $123 million.
The interest payments provided a tax savings of 35% × $350 million = $123 million.
 Cash Flows to Investors 
 Cash Flows to Investors 

  
  (Interest Tax Shield)
with Leverage


 without Leverage 
MM Proposition I with Taxes
The total value of the levered firm exceeds the value of the firm without leverage due to
the present value of the tax savings from debt.
V L  V U  PV (Interest Tax Shield)
Value of the Firm w/o taxes
The Interest Tax Shield with Permanent Debt
Suppose a firm borrows debt D and keeps the debt permanently. If the firm’s marginal
tax rate is c , and if the debt is riskless with a risk-free interest rate rf , then the interest
tax shield each year is c × rf × D, and the tax shield can be valued as a perpetuity.
PV (Interest Tax Shield) 
 c  Interest
rf
 c  D

 c  (rf  D)
rf
The Weighted Average Cost of Capital with Taxes
With tax-deductible interest, the effective after-tax borrowing rate is r(1 − c) and the
weighted average cost of capital becomes
rwacc 
rwacc 
E
D
rE 
rD (1   c )
E  D
E  D
E
D
D
rE 
rD 
rD c
E  D
E  D
E  D
Pretax WACC
Reduction Due
to Interest Tax Shield
Figure 15.2 The WACC with and without Corporate Taxes
How does the reduction of WACC (due to taxes) impact the value of the firm?
P0 
FCF
rWACC
Value of the Firm
Textbook Example 15.3
Pr etax WACC 
1
.5
* 10% 
* 6%  8.67%
1  .5
1  .5
4.25
 91
8.67%  4%
1
.5
WACC 
* 10% 
* 6% * (1  .35)  7.97%
1  .5
1  .5
4.25
VL 
 107
7.97%  4%
VU 
15.3 Recapitalizing to Capture the Tax Shield
Recapitalizing means to change the capital structure. How does this impact
shareholders?
Assume that Long-Term Industries wants to boost its stock price. The company currently
has 40 million shares outstanding with a market price of $10 per share and no debt.
Midco has had consistently stable earnings, and pays a 30% tax rate. Management plans
to borrow $200 million on a permanent basis and they will use the borrowed funds to
repurchase outstanding shares.
The Tax Benefit
Without leverage
VU = (40 million shares) × ($10/share) = $400 million
If Midco borrows $100 million using permanent debt, the present value of the
firm’s future tax savings is
PV(interest tax shield) = cD = 30% × $200 million = $60 million
Thus the total value of the levered firm will be
VL = VU + cD = $400 million + $60 million = $460 million
Because the value of the debt is $200 million, the value of the equity is
E = VL − D = $460 million − $200 million = $260 million
Although the value of the shares outstanding drops to $260 million,
shareholders will also receive the 2100 million that Midco will pay out through
the share repurchase.
In total, they will receive the full $460 million, a gain of $60 million over the
value of their shares without leverage.
The Share Repurchase
Assume Midco repurchases its shares at the current price of $10/share. The firm will
repurchase 6.67 million shares.
$200 million ÷ $10/share = 20 million shares
It will then have 20 million shares outstanding.
40 million − 20 million = 20 million
The total value of equity is $260 million; therefore the new share price is.
$260 million ÷ 20 million shares = $13.00
Shareholders that keep their shares earn a capital gain of $2.625 per share.
$13.00 − $10 = $3.00
The total gain to shareholders is.
$3.00/share × 20 million shares = $60 million
If the shares are worth $13/share after the repurchase, why would shareholders tender
their shares to Midco at $10/share?
How can the company get shareholders to participate??
No Arbitrage Pricing
If investors could buy shares for $10 immediately before the repurchase, and they could
sell these shares immediately afterward at a higher price, this would represent an
arbitrage opportunity.
Realistically, the value of the Midco’s equity will rise immediately from $400 million to
$460 million after the repurchase announcement. With 20 million shares outstanding,
the share price will rise to $16.75 per share.
$460 million ÷ 20 million shares = $13 per share
With a repurchase price of $13, the shareholders who tender their shares and the
shareholders who hold their shares both gain $1.75 per share as a result of the
transaction.
$20.00 − $10 = $10
The benefit of the interest tax shield goes to all 20 million of the original shares
outstanding for a total benefit of 60 million.
$3.00/share × 20 million shares = $60 million
When securities are fairly priced, the original shareholders of a firm capture the full
benefit of the interest tax shield from an increase in leverage.
15.4 Personal Taxes
The cash flows to investors are typically taxed twice.
Once at the corporate level and then again when they receive their interest or
divided payment.
For individuals:
Interest payments received from debt are taxed as income.
Equity investors also must pay taxes on dividends and capital gains.
Including Personal Taxes in the Interest Tax Shield
The amount of money an investor will pay for a security depends on the cash flows the
investor will receive after all taxes have been paid.
Personal taxes reduce the cash flows to investors and can offset some of the corporate
tax benefits of leverage.
To determine the true tax benefit of leverage, the combined effect of both corporate
and personal taxes needs to be evaluated.
Including Personal Taxes in the Interest Tax Shield (cont'd)
In general, every $1 received after taxes by debt holders from interest payments costs equity
holders $(1 − *) on an after-tax basis, where:
Effective Tax Advantage of Debt
Including Personal Taxes
in the Interest Tax Shield (cont'd)
When there are no personal taxes on debt income
(i = 0) or when the personal tax rates on debt and equity income are the same (i = e ), the
formula reduces to * = c.
When equity income is taxed less heavily (e is less than i), then * is less than c.
Valuing the Interest Tax Shield with Personal Taxes (cont'd)
With personal taxes the firm’s equity and debt costs of capital will adjust to compensate
investors for their respective tax burdens.
The net result is that a personal tax disadvantage for debt causes the WACC to decline
more slowly with leverage than it otherwise would.
Value of the Firm
The bottom line:
Calculating the effective tax advantage of debt accurately is extremely difficult.
A firm must consider the tax bracket of its typical debt holders, and the tax bracket
and holding period of its typical equity holders.
The tax advantage of debt will vary across firms and from investor to investor.
15.5 Optimal Capital Structure with Taxes
Do Firms Prefer Debt?
When firms raise new capital from investors, they do so primarily by issuing debt.
In most years aggregate equity issues are negative, meaning that on average, firms are
reducing the amount of equity outstanding by buying shares.
While firms seem to prefer debt when raising external funds, not all investment is externally
funded.
Most investment and growth is supported by internally generated funds.
Even though firms have not issued new equity, the market value of equity has risen
over time as firms have grown. For the average firm, the result is that debt as a
fraction of firm value has varied in a range from 30–45%.
The use of debt varies greatly by industry.
Firms in growth industries like biotechnology or high technology carry very little debt, while
airlines, automakers, utilities, and financial firms have high leverage ratios.
Limits to the Tax Benefit of Debt
The optimal level of leverage from a tax saving perspective is the level such that interest
equals EBIT.
At the optimal level of leverage, the firm shields all of its taxable income and it does not
have any tax-disadvantaged excess interest.
Growth and Debt
Growth will affect the optimal leverage ratio.
To avoid excess interest, a firm with positive earnings should have a level of debt such that
interest payments are below its expected taxable earnings.
Interest  rD  Debt  EBIT
or
Debt  EBIT / rD
From a tax perspective, the firm’s optimal level of debt is proportional to its current earnings.
However, the value of the firm’s equity will depend on the growth rate of earnings:
The higher the growth rate, the higher the value of equity. As a result, the optimal
proportion of debt in the firm’s capital structure [D / (E + D)] will be lower, the higher the
firm’s growth rate.
Other Tax Shields
There are numerous provisions in the tax laws for deductions and tax credits, such as depreciation,
investment tax credits, carryforwards of past operating losses, etc.
To the extent that a firm has other tax shields, its taxable earnings will be reduced and it will rely
less heavily on the interest tax shield.
The Low Leverage Puzzle
Two important patterns.
Firms have used debt to shield a greater percentage of their earnings from taxes in more
recent years (mirroring the increase in the effective tax advantage of debt).
Firms have far less leverage than our analysis of the interest tax shield would predict.
It would appear that firms, on average, are under-leveraged. However, it is hard to accept that
most firms are acting suboptimally.
In reality, there is more to the capital structure story than discussed so far.
A key item missing from the analysis thus far is that increasing the level of debt increases the
probability of bankruptcy.
If bankruptcy is costly, these costs might offset the tax advantages of debt financing.