Tax Saving Methods Of Overseas Corporation

Tax Saving Methods Of Overseas Corporation

This eBook guide can teach you how to set up an offshore corporation without having to fly overseas or hire an accountant. By doing this, you can avoid taxes on your income, even if you make more than $1,000,000. You get to keep it all! You will learn how a tax haven works, learn how to withdraw your earnings, and keep this all totally legal and aboveboard. Using this method, you can legally avoid having to pay huge amounts of cash for just making money. You should not have to give up the money that you rightfully made just because the government says so. You can also avoid things like inheritance tax and make your tax returns much easier. This is NOT tax evasion! This is legal method of setting up your business, that is totally aboveboard. If you want to learn how to save money for your business, this method is for you! Continue reading...

Tax Saving Methods Of Overseas Corporation Summary


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Tax Evasion or Tax Fraud

With regard to taxes, tax evasion is not considered a crime in Switzerland, although I strongly suggest avoiding it, since there could be stiff penalties at home if caught, including prison and fines. Getting caught not filing the Treasury form and being found guilty of tax evasion or tax fraud would get you more time in jail than Paris Hilton recently experienced and most likely, a lot more. Also, tax fraud is illegal in Switzerland. As an example, tax fraud would be if you failed to file your annual tax return or lied on your deductions to fraudulently reduce your tax liability, as discussed in Chapter 2. The problem might be with the perception of the difference between actual fraud and just evasion. You could find yourself in the gray zone of interpretation. Let's say that the U.S. government wants you badly for tax evasion, but it can' t specifically find a technicality in which it could sling tax fraud at you. So, it might stretch its reasoning capacity to gain a sympathetic ear...

Corporate Taxes and the Impact of Financing on Real Asset Valuation

Understand the effect of leverage on the cost of equity and the beta of the firm when there is a corporate tax deduction for interest payments. 3. Understand the weighted average cost of capital (WACC) and the effect of leverage on the WACC when there is a corporate tax deduction for interest payments. Chapter 13 Corporate Taxes and the Impact of Financing on Real Asset Valuation 461 The WACC method may be conceptually easier to understand because it discounts only one set of cash flows, while the APV method discounts separately the cash flows of the project and the cash flows of the tax savings or other debt subsidies. In addition, the WACC method is used more widely, so that analysts presenting a WACC-based valuation will be able to communicate their analysis to others more easily. It is important to understand both approaches the APV method because it is a superior, more flexible approach, and the WACC method because it is more widely used and understood.

CS Corporate Taxes

Example - You own all the equity of Space Babies Diaper Co The company has no debt. The company's annual cash flow is 1,000, before interest and taxes. The corporate tax rate is 40 . You have the option to exchange 1 2 of your equity position for 10 bonds with a face value of 1,000.

How Corporate Taxes Affect the Capital Structure Choice

In the U.S., the existence of corporate taxes favors debt financing. This is because, in the U.S., interest is a tax-deductible corporate expense. However, since dividends are viewed as distributions of profits rather than expenses of doing business, they are not tax deductible.7 Howard Hughes's perceptive analysis of the tax benefits of debt financing, described in the chapter's opening vignette, predated the academic discussion of debt and taxes by several years. This section explores the types of tax benefits he mentioned in more detail, specifically considering situations in which there are (1) corporate taxes, (2) tax-deductible interest expenses, and (3) no personal taxes. In the next section and in Chapter 15 we will explore the effects of personal taxes.

The implications of corporate taxes for capital structure

No one would expect the gains to apply at extreme debt ratios. For example, if a firm borrows heavily, all its operating income may go to pay interest and therefore there are no corporate taxes to be paid. There is no point in such firms borrowing any more. All this suggests that there may come a point at which the tax savings from debt level off and may even decline. But it doesn't explain why highly profitable companies with large tax bills often thrive with little or no debt. There are clearly factors besides tax to consider.

Example 143 The Effect of Corporate Taxes on Cash Flows to Equity and Debt Holders

Compute Stanley's cash flow (1) in the original low-leverage scenario and (2) in the high-leverage scenario in which the investor attempts to undo the firm's capital structure change by selling 5,000 of his shares and using the proceeds to buy 5,000 in bonds. Assume there is a corporate tax on earnings at a rate of Tc. ital structure, and that there are no transaction costs or opportunities for arbitrage. With corporate taxes but no personal taxes, a firm's optimal capital structure will include enough debt to completely eliminate the firm's tax liabilities.

Detour on Discounting and Debt Capacity with Corporate Taxes

Consider a corporation that lends 100 for a year. If the interest rate is 10 percent, the firm will receive 110 at the end of the year. Of this amount, 10 is interest and the remaining 100 is the original principal. A corporate tax rate of 34 percent implies taxes on the interest of 3.40 (0.34 X 10). Thus, the firm ends up with 106.60 ( 110 - 3.40) after taxes on a 100 investment. Taxes (interest rate is 10 percent and corporate tax rate is 34 percent) General principle In a world with corporate taxes, riskless cash flows should be discounted at the after-tax interest rate. General principle In a world with corporate taxes, riskless cash flows should be discounted at the after-tax interest rate. The above two paragraphs show a very important result the firm could not care less whether it received 100 today or 106.60 next year.4 If it received 100 today, it could lend it out, thereby receiving 106.60 after corporate taxes at the end of the year. Conversely, if it knows today that it...

Mm Propositions I And Ii With Corporate Taxes

We can start by considering what happens to M& M Propositions I and II when we consider the effect of corporate taxes. To do this, we will examine two firms, Firm U (unlevered) and Firm L (levered). These two firms are identical on the left-hand side of the balance sheet, so their assets and operations are the same. We assume that EBIT is expected to be 1,000 every year forever for both firms. The difference between the firms is that Firm L has issued 1,000 worth of perpetual bonds on which it pays 8 percent interest each year. The interest bill is thus .08 X 1,000 80 every year forever. Also, we assume that the corporate tax rate is 30 percent.

Corporate Taxes Amd Caepotal Structure

We can start by considering what happens when we consider the effect of corporate taxes. To do this, we will examine two firms. Firm U (unlevereti) and Firm L (levered). These two firms are identical on the left-hand side of the balance sheet, so their assets and operations are the same. We assume that EBIT is expected to be 1,000 every year forever for both firms. The difference between the two firms ts that Firm L has issued 1,000 worth of perpetual bonds on which it pays 8 percent interest each year. The interest bill is thus .08 X 1,000 80 every year forever. Also, we assume that the corporate tax rate is 30 percent.

Modigliani and Miller The Effect of Corporate Taxes

MM published a follow-up paper in 1963 in which they relaxed the assumption that there are no corporate taxes.10 The Tax Code allows corporations to deduct interest payments as an expense, but dividend payments to stockholders are not deductible. This differential treatment encourages corporations to use debt in their capital structures. This means that interest payments reduce the taxes paid by a corporation, and if a corporation pays less to the government, more of its cash flow is available for its investors. In other words, the tax deductibility of the interest payments shields the firm's pre-tax income. Under their assumptions, they showed that the present value of the tax shield is equal to the corporate tax rate, T, multiplied by the amount of debt, D

Some Other Corporate Tax Avoidance Schemes

Wall Street and Main Street employ armies of tax experts to help their clients avoid taxes, but this is really an arms race between the IRS (Congress) and investors. Investors keep looking for new tax avoidance schemes and the IRS tries to close these new loopholes. There are a large number of both past (now closed) and current tax avoidance schemes. Some of the more noteworthy remaining tax reduction schemes are as follows For example, the Financial Times reported on February 10, 1994, that the 2.5B GKN corporation made a hostile bid for the 300M Westland corporation, solely because GKN needed Westland's NOLs to reduce its own corporate taxes due. Should the government prevent corporate tax avoidance Before such corporate tax avoidance schemes outrage you too much, you should realize that you may even be lucky if tax lawyers and Congress help many U.S. companies succeed in escaping some of their tax burdens. First, corporations are just vehicles owned by investors. Corporate income...

Example 146 The Effect of Corporate Taxes and Personal Taxes on the Tax Gain from Leverage

In 2000 the maximum personal income tax rate was 40 percent, the maximum corporate tax rate was 35 percent, and the rate on capital gains was 20 percent. Using these tax rates, what is the tax gain from leverage Since firms with low taxable earnings will not always be able to take advantage of the tax gain associated with leverage, they will prefer equity financing if the returns on equity and debt satisfy equation (14.8) for those firms that will be paying corporate taxes with certainty that is, rE (1 - Tc)rD, where Tc (throughout this subsection) is the corporate tax rate for those firms that will be paying the full corporate tax rate. In other words, firms that are indifferent between debt and equity when they are assured of using the debt tax deduction will prefer equity financing when they are uncertain about being able to use the tax deduction. For such firms to issue debt, (1) the aftertax cost of debt (adjusted for its risk premium) must be less than the (risk-premium...

Gl 15 Business Taxes

Taxes are a fact of life, and businesses, like individuals, must pay taxes on income. The income of sole proprietorships and partnerships is taxed as the income of the individual owners corporate income is subject to corporate taxes. Regardless of their legal form, all businesses can earn two types of income ordinary and capital gains. Under current law, these two types of income are treated differently in the taxation of individuals they are not treated differently for entities subject to corporate taxes. Frequent amendments are made to the tax code. i l iHlci Corporate Tax Rate Schedule

Corporate Tax Rates

Corporate tax rates in effect for 2002 are shown in Table 2.3. A peculiar feature of taxation instituted by the Tax Reform Act of 1986 and expanded in the 1993 Omnibus Budget Reconciliation Act is that corporate tax rates are not strictly increasing. As shown, corporate tax rates rise from 15 percent to 39 percent, but they drop back to 34 percent on income over 335,000. They then rise to 38 percent and subsequently fall to 35 percent. According to the originators of the current tax rules, there are only four corporate rates 15 percent, 25 percent, 34 percent, and 35 percent. The 38 and 39 percent brackets arise because of surcharges applied on top of the 34 and 35 percent rates. A tax is a tax is a tax, however, so there are really six corporate tax brackets, as we have shown.

Tax evasion

Politicians often complain about tax evasion. Evasion is the illegal (and immoral) manipulation of business affairs to escape taxation. An example could be the directors of a family-owned company taking cash sales for their own expenditure. Another example might be the payment of a low salary (below the threshold of income tax) to a family member not working in the company, thus reducing profits in an attempt to reduce corporation tax. It is easy to understand the illegality and immorality of such practices. When politicians complain of tax evasion, they tend not to distinguish between evasion and avoidance.

Tax Havens

Many multinational corporations have found an interesting but controversial way to reduce their tax burdens By shifting some of their operations to countries with low or nonexistent taxes, they can significantly reduce their total tax bills. Over the years, several countries have passed tax laws that make the countries tax havens designed to attract foreign investment. Notable examples include the Bahamas, Grand Cayman, and the Netherlands Antilles. While activities such as Murdoch's are legal, some have questioned their ethics. Clearly, shareholders want corporations to take legal steps to reduce taxes. Indeed, many argue that managers have a fiduciary responsibility to take such actions whenever they are cost effective. Moreover, citizens of the various tax havens benefit from foreign investment. Who loses Obviously, the United States loses tax revenue whenever a domestic corporation establishes a subsidiary in a tax haven. Ultimately, this loss of tax revenue either reduces...

Corporate Taxes

Depend only on the corporate tax rate1 and on the ability of L to earn enough to cover interest payments. The corporate tax rate has been pretty stable. (It did fall from 46 to 34 percent after the Tax Reform Act of 1986, but that was the first material change since the 1950s.) And the ability of L to earn its interest payments must be reasonably sure otherwise it could not have borrowed at 8 percent.2 Therefore we should discount the interest tax shields at a relatively low rate. Under these assumptions, the present value of the tax shield is independent of the return on the debt rD. It equals the corporate tax rate Tc times the amount borrowed D corporate tax rate X expected interest payment expected return on debt 1Always use the marginal corporate tax rate, not the average rate. Average rates are often much lower than marginal rates because of accelerated depreciation and other tax adjustments. For large corporations, the marginal rate is usually taken as the statutory rate, which...

Explain Why Each Of The Following Situation Is An Agency Problem And What Costs To The Firm

PI-6 Corporate taxes Tantor Supply, Inc., is a small corporation acting as the exclusive distributor of a major line of sporting goods. During 2009 the firm earned 92,500 before taxes. a. Calculate the firm's tax liability using the corporate tax rate schedule given in Table 1.4. 1UPJ Average corporate tax rates Using the corporate tax rate schedule given in Table 1.4, perform the following USI Marginal corporate tax'rates Using the corporate tax rate schedule given in Table 1.4, perform the following

How should financial analysts treat them

A company that posts a loss for a given period owing to exceptional circumstances will recognise a deferred tax asset in its consolidated accounts, the double entry to which will be a tax benefit that reduces the amount of the after-tax reported loss. Please note that the deferred tax asset does not represent an amount due from the State, but only a future tax saving assuming positive net income in the near future.

State and Local Taxes

A survey by PricewaterhouseCoopers LLP found that corporate tax managers spent 44 of their time on state and local taxes. State and local taxes also fall into the categories of transaction, wealth, and income taxes. Sales and use taxes are paid by retail consumers of goods. They are remitted to businesses, which in turn remit these transaction taxes to local governments. The primary wealth tax is a property tax, assessed to owners of both realty and personalty. Forty-four of the states impose a corporate income tax. To partly alleviate double taxation, state corporate income taxes are deducted (expensed) on the federal corporate return (i.e., they reduce the U.S. tax bill). State and local taxes are discussed in more detail in Chapter 7.

Seeking Protection with Limited Liability Companies

LLCs let sole proprietorships and partnerships have their cake and eat it, too They get the same legal protection from liability as a corporation but don't have to pay corporate taxes or file all the forms required of a corporation. In fact, the IRS treats LLCs as partnerships or sole proprietorships unless they ask to be taxed as corporations by using Form 8832, Entity Classification Election.

Cash Flows to and from the Firm

Suppose we start with the firm selling shares of stock and borrowing money to raise cash. Cash flows to the firm from the financial markets (A). The firm invests the cash in current and fixed (or long-term) assets (B). These assets generate some cash (C), some of which goes to pay corporate taxes (D). After taxes are paid, some of this cash flow is reinvested in the firm (E). The rest goes back to the financial markets as cash paid to creditors and shareholders (F).

Disadvantages of Corporations

There are several disadvantages to the corporate form of ownership. Most corporations must pay taxes on their incomes. Corporate taxes are separate from the taxes paid by shareholders on dividends received from the company. (Some corporations, however, especially smaller ones, are not taxed separately.) Another disadvantage is that corporations are regulated by various state and federal government agencies. These regulations require corporations to comply with many state and federal rules concerning business practices and reporting of financial information. Corporations must file many reports with government agencies and make public disclosure of their business activities. Compliance with these regulations is costly. Also, some of the required disclosures may be helpful to competitors. Partnerships and proprietorships are regulated also, but the degree of regulation normally is much less than for corporations.

South Sea Baubles Has The Following Incomplete Balance Sheet And Income Statement

Corporate tax Companies pay tax on their income. Table 2.4 shows that there are special low rates of corporate tax for small companies, but for large companies (those with income over 18.33 million) the corporate tax rate is 35 percent. Thus for every 100 that the firm earns it pays 35 in corporate tax. The company is also allowed to deduct interest paid to debtholders when calculating its taxable income, but dividends paid to shareholders are not deductible. These dividends are therefore paid out of after-tax income. Table 2.5 provides an example of how interest payments reduce corporate taxes. Corporate tax rates, 1999 Firms A and B both have earnings before interest and taxes (EBIT) of 100 million, but A pays out part of its profits as debt interest. This reduces the corporate tax paid by A. Firms A and B both have earnings before interest and taxes (EBIT) of 100 million, but A pays out part of its profits as debt interest. This reduces the corporate tax paid by A. Financial...

Net Operating Loss Carrybacks And Carryovers

Here's how carrybacks and carryovers work. Suppose that in the year 2000, a corporation has a 100 million net operating loss. To simplify the calculations, let's also assume that the corporate tax rate is a flat 40 of income. Suppose further that the corporation paid taxes on income as follows in the three years prior to 2000

Taxation Outside Of The United States

The basic corporate income tax imposed by central governments is a fixed percentage or an increasing percentage of the statutorily determined corporate income. Countries typically tax resident corporations on worldwide income regardless of whether the income is repatriated. Nonresident corporations, that is, corporations whose corporate seat and place of management are outside the country, are typically subject only to corporate taxes derived from within the country. The rate varies significantly from country to country. The range of corporate tax rates is shown in Exhibit 5.6. These tax rates, which are 3 The Walt Disney Company 2001 Annual Report, p. 69. Because state taxes are deductible for federal income tax purposes, the state tax rate reflects this benefit and, hence, is lower than the statutory state corporate tax rate. from KPMG International's Corporate Tax Rate Survey for January 2002, are estimates of the corporate tax burden, considering both national and local tax rates....

Constraints to the Exercise of Governance by Creditor Banks In the

In a significant move, in 2001 the Ministry of Finance reduced the tax burden on banks and is allowing greater flexibility in writing off bad debts. The business tax, applicable to gross revenues, was reduced from 8 to 7 percent and is to be reduced further to 5 percent over the next two years. The 1 percent limit on tax-deductible provisions was changed to allow banks the flexibility to provision against loan losses. The financial supervisors have the authority to ask for additional provisions, if needed. The new rules specified a five-year framework within which financial institutions are encouraged to absorb historical losses through progressive provisioning (World Bank 2001c).

Problems and Questions

Novell, which had a market value of equity of 2 billion and a beta of 1.50, announced that it was acquiring WordPerfect, which had a market value of equity of 1 billion, and a beta of 1.30. Neither firm had any debt in its financial structure at the time of the acquisition, and the corporate tax rate was 40 .

Calculating NPV in Other Countries and Currencies

Profits from Flanel's project are liable to the French rate of corporate tax. This is currently about 37 percent, a trifle higher than the rate in the United States.7 7The French tax rate is made up of a basic corporate tax rate of 33.3 percent plus a surtax of 3.33 percent.

Tax Management In Action

While dividends are ineffectual, salary payments are useful for splitting the tax liability between the corporation and the owner. To see this, suppose a U.S. corporation has 200,000 of taxable income, before paying its sole shareholder president a salary. If the corporation is in the 34 bracket and the owner is in the 31 bracket, paying salary results in a tax savings of 3 (i.e., 34 to 31 ). Similarly, a manager in a large, publicly traded corporation can negotiate part of this tax spread in the form of a higher salary. There are limits on this tax-saving technique. Only a reasonable level of compensation is deductible, and it is subject to payroll taxes. Perquisites, for a C corporation, are the ultimate tax shelter insofar as they reduce corporate taxes while (depending on the type of perquisite) often being tax free to the managers shareholders. Similar to salary, managers can negotiate for part of this tax savings in a large corporation. (See Example 3.8.)

Questions and Problems

8.8 Kids & Toys Inc. has purchased a 200,000 machine to produce toy cars. The machine will be fully depreciated by the straight-line method for its economic life of five years and will be worthless after its life. The firm expects that the sales price of the toy is 25 while its variable cost is 5. The firm should also pay 350,000 as fixed costs each year. The corporate tax rate for the company is 25 percent, and the appropriate discount rate is 12 percent. What is the present value break-even point The corporate tax rate is 34 percent. 8.10 Ms. Thompson, as the CFO of a clock maker, is considering an investment of a 420,000 machine that has a seven-year life and no salvage value. The machine is depreciated by a straight-line method with a zero salvage over the seven years. The appropriate discount rate for cash flows of the project is 13 percent, and the corporate tax rate of the company is 35 percent. Calculate the NPV of the project in the following scenario. What is your...

Worried about an Audit

A New York Times article dated May 3, 2007, was headlined IRS Curtails Many Audits in Tax Havens. In summary, the story said that although the U.S. Internal Revenue Service believes that as much as 40 billion is being moved offshore annually from U.S. investment and business income, the tax havens including Switzerland, of course and their bank secrecy have hampered the normal audit process, which requires about two and a half years to complete. Often the IRS ventures into fishing expeditions to see what it can dredge up, but the fact is, even if IRS agents have a clue of impropriety or are confident that there' s tax evasion, often they choose to terminate the audit prematurely or not pursue the issue at all. Why When they discover that a taxpayer has an offshore corporation or an offshore bank account, agents realize it's not going to be easy to finish their examination within the three-year statute period allotted them for conducting an audit. And that includes tax havens where...

The Tax Shield Approach

Where T is again the corporate tax rate. Assuming that T 34 , the OCF works out to be The second part of OCF in this approach is the depreciation deduction multiplied by the tax rate. This is called the depreciation tax shield. We know that depreciation is a noncash expense. The only cash flow effect of deducting depreciation is to reduce our taxes, a benefit to us. At the current 34 percent corporate tax rate, every dollar in depreciation expense saves us 34 cents in taxes. So, in our example, the 600 depreciation deduction saves us 600 X .34 204 in taxes. The tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate.

Issues of Selecting Measurements

Taxes shown on the financial statements is not the actual amount that the company paid. It is essentially the corporate tax rate, currently 34 percent, multiplied by the amount of net income before tax. As a result, many analysts use the pretax amount to measure profitability.

The problem of distinguishing between avoidance and evasion

As an example to illustrate the problems that could arise, a client company has carried out a transaction to avoid taxation, but failed to minute the details as discussed at a directors' meeting. If the accountant were to correct this act of omission in arrear, this would be a move from tax avoidance towards tax evasion. Another example of such a move from tax avoidance to tax evasion might be where an accountant in informing the Inland Revenue of a tax-avoiding transaction fails to detail aspects of the transaction which might show it in a disadvantageous light. Companies can move profit centres from high-taxation countries to low-taxation countries by setting up subsidiaries therein. These areas, known in extreme cases as tax havens, are disliked by governments. Tax havens are countries with very low, or nil, tax rates on some or all forms of income. They could be classified into two groups 1. the zero rate and low tax havens, 2. the tax haven that imposes tax at normal rates but...

Income Tax History Of

With some modifications, the basic structure of the income tax remained in place during the post-World War II years and continues to the present. Individual tax rates were reduced from wartime highs, and the tax base began to narrow with the adoption of exemptions, deductions, and credits. Inflation in the 1960s and 1970s created a condition called bracket creep.'' Taxpayers whose monetary incomes were increasing because of inflation, but with no equivalent increase in purchasing power, were pushed into higher tax brackets and thus subject to higher marginal tax rates. Because the corporate rate structure was not progressive, bracket creep did not apply to corporations. Although the corporate and individual income taxes had generated roughly the same revenue in 1950, by 1980, partially as a result of bracket creep, the individual income tax generated four times the revenue of the corporate tax.

Types of international bonds

Perhaps the greatest advantage of all types of international bonds for individual investors is that interest income on them is exempt from withholding taxes at the source. Investors must report their interest income to their national authorities, but both tax avoidance and tax evasion are extremely widespread. Official institutions hold a large portion of investment in international bonds and are not liable for tax. Another large class of investors in international bonds consists of private institutions. These private institutions legally avoid tax by being in tax-haven countries.

Debt Has A Tax Advantage

Flows on equity (such as dividends) have to be paid out of after-tax cash flows. For the most part, this is true in other countries as well, though some countries try to provide partial protection against the double taxation of dividends by providing a tax credit to investors who receive the dividends for the corporate taxes paid (Britain) or by taxing retained earnings at a rate higher than dividends (Germany). The tax benefits from debt can be presented in three ways. The first two measure the benefit in absolute terms whereas the third measures it as a percentage cost. In the first approach, the dollar tax savings in any financial year created by interest expenses can be computed by multiplying the interest expenses by the marginal tax rate of the firm. Consider a firm that borrows B to finance it operations, on which it faces an interest rate of r , and assume that it faces a marginal tax rate of_t on income. The annual tax savings from the interest tax deduction can be calculated...

Will It Always Be Possible To Borrow Etf Shares At Lowcost For Risk Management Applications

Under the 2003 Tax Act, dividends can be affected by a similar distinction between actual or passed-through dividends and payments in lieu of dividends. Corporations have had to exercise care that the dividends they have received on common and preferred stocks have qualified for the tax code's corporate tax dividend-received deduction by being actual dividend payments or pass-throughs rather than payments in lieu. Most individual investors have not had to worry about the character of such payments until now. For 2003, the new tax act provides that as long as an individual investor has no reason to believe that what he or she is receiving is a payment in lieu, the taxpayer can assume dividend payments from a brokerage firm or other custodian that holds the taxpayer's stocks, equity mutual funds or equity ETF shares are qualified dividends. New Treasury rules dictate that financial intermediaries report dividend

The Irrelevance of Debt with Taxes

It is clear, in the Miller-Modigliani model, that when taxes are introduced into the model, debt does affect value. In fact, introducing both taxes and bankruptcy costs into the model creates a trade off, where the financing mix of a firm affects value, and there is an optimal mix. In an address in 1979, however, Merton Miller argued that the debt irrelevance theorem could apply even in the presence of corporate taxes, if taxes on the equity and interest income individuals receive from firms were included in the analysis. To demonstrate the Miller proof of irrelevance, assume that investors face a tax rate of td on interest income and a tax rate of te on equity income. Assume also that the firm pays an interest rate of r on debt and faces a corporate tax rate of tc. The after-tax return to the investor from owning debt can then be written as VL Vu + 1- (1-tc) (1-te)) (1-td) B where VL is the value of the firm with leverage, Vy is the value of the firm without leverage, and B is the...

Appendix 16A Some Useful Formulas of Financial Structure

Cost of capital to an all-equity firm. In a world of no corporate taxes, the r0. However, with corporate taxes, r0 is above rWACC for a levered firm. Model II (Corporate Tax, TC > 0 No Personal Taxes, TS TB 0) rs ro + (1 - Tc) X (ro - rB) X B S Model III (Corporate Tax, TC > 0 Personal Tax, TB > 0 TS > 0)

Appendix 16B The Miller Model and the Graduated Income

Now consider a courageous firm contemplating a 1,000 issue of debt. What is the interest rate that the firm can pay and still be as well off as if it issued equity Because debt is tax deductible, the after-corporate tax cost of debt is (1 TC) X rB. However, equity is not deductible at the corporate level, so the after-tax cost of equity is rS. Thus, the firm is indifferent to whether it issues debt or equity when 1. In aggregate, the corporate sector will issue just enough debt so that individuals with tax brackets equal to and below the corporate tax rate, TC, will hold debt, and individuals with higher tax brackets will not hold debt. Thus, individuals in these higher brackets will hold stock. We assume that investors are risk-neutral and that equity income is untaxed at the personal level for all investors (i.e., TS 0). All investors can earn a tax-free return of 5.4 percent by investing in foreign real estate therefore, this is the return on equity. The corporate tax rate is 35...

An Analysis of the Project

XWe use the term adjusted basis rather than book value because we are concerned with the firm's tax books, not its accounting books. This point is treated later in the chapter in the section entitled Which Set of Books The current market value of the building and land is 227,272.73. We will assume the corporate tax rate is 34 percent, the basis is zero, and the after-tax net is 227,272.73 X (1 - 0.34) 150,000. *We assume that the ending market value of the capital investment at year 5 is 30 (in thousands). Capital gain is the difference between ending market value and adjusted basis of the machine. The adjusted basis is the original purchase price of the machine less depreciation. The capital gain is 24.24 ( 30 5.76). We will assume the incremental corporate tax rate for Baldwin on this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax here is 8.24 0.34 X ( 30 5.76) . The after-tax capital gain is 30 0.34 X ( 30 5.76) 21.76. *We...

Taxes and the Weighted Average Cost of Capital

To illustrate, suppose a firm borrows 1 million at 9 percent interest. The corporate tax rate is 34 percent. What is the aftertax interest rate on this loan The total interest bill will be 90,000 per year. This amount is tax deductible, however, so the 90,000 interest reduces the firm's tax bill by .34 X 90,000 30,600. The aftertax interest bill is thus 90,000 - 30,600 59,400. The aftertax interest rate is thus 59,400 1 million 5.94 . Notice that, in general, the aftertax interest rate is simply equal to the pretax rate multiplied by 1 minus the tax rate. If we use the symbol TC to stand for the corporate tax rate, then the aftertax rate that we use can be written as RD X (1 - TC). For example, using the numbers from the preceding paragraph, we find that the aftertax interest rate is 9 X (1 - .34) 5.94 . The B. B. Lean Co. has 1.4 million shares of stock outstanding. The stock currently sells for 20 per share. The firm's debt is publicly traded and was recently quoted at 93 percent of...

The Federal Income Tax System

Our tax laws can be changed by Congress, and in recent years changes have occurred frequently. Indeed, a major change has occurred, on average, every three to four years since 1913, when our federal income tax system began. Further, certain parts of our tax system are tied to the inflation rate, so changes occur automatically each year, depending on the rate of inflation during the previous year. Therefore, although this section will give you a good background on the basic nature of our tax system, you should consult current rate schedules and other data published by the Internal Revenue Service (available in U.S. post offices and on the Web) before you file your personal or business tax returns.

Corporate Income Taxes

The corporate tax structure, shown in Table 9-7, is relatively simple. To illustrate, if a firm had 65,000 of taxable income, its tax bill would be TABLE 9-7 Corporate Tax Rates as of January 2001 TABLE 9-7 Corporate Tax Rates as of January 2001 Interest and Dividend Income Received by a Corporation Interest income received by a corporation is taxed as ordinary income at regular corporate tax rates. Of course, it is generally not possible to finance exclusively with debt capital, and the risk of doing so would offset the benefits of the higher expected income. Still, the fact that interest is a deductible expense has a profound effect on the way businesses are financed our corporate tax system favors debt financing over equity financing. This point is discussed in more detail in Chapters 6 and 13.

Subchapter S Corporations

Many entrepreneurs have turned to the subchapter S election to eliminate the two layers of tax otherwise payable upon sale or dissolution of a corporation. The corporate tax otherwise payable upon the gain realized on the sale of corporate assets is eliminated by the use of the subchapter S election as long as the election has been in effect for 10 years or, if less, since the corporation's inception. Finally, many entrepreneurs elect subchapter S status for their corporations if they expect to show losses in the short term. These losses can then be passed through to their individual tax returns to act as a shelter for other income. When the corporation begins to show a profit, the election can be reversed.

Suggested Readings

In several recent articles, John R. Graham estimates effective corporate tax rates and their input on corporate financing policy. Graham, John R. Michael Lemmon and James Schollheirn. Debt, Leases, Taxes and the Endogeneity of Corporate Tax Status. Journal of Finance 53 (1998).

The Klaven Corporation Had Operating Income Ebit Of 750 000 And Depreciation

CORPORATE TAX LIABILITY CORPORATE TAX LIABILITY The Shrieves Corporation has 10,000 that it plans to invest in marketable securities. It is choosing between AT& T bonds, which yield 7.5 percent, state of Florida muni bonds, which yield 5 percent, and AT& T preferred stock, with a dividend yield of 6 percent. Shrieves' corporate tax rate is 35 percent, and 70 percent of the dividends received are tax exempt. Assuming that the investments are equally risky and that Shrieves chooses strictly on the basis of after-tax returns, which security should be selected What is the after-tax rate of return on the highest-yielding security

Common Disasters and IRA Plans

If you were to pass away with your spouse in a common disaster such as an auto accident or home fire, do you know who would receive the proceeds of your pension, profit sharing plans, or IRAs Most retirees think that their children would receive their account values but are not really sure. Take time to ensure that either your children are named as contingent beneficiaries of your retirement programs or that a qualified trust is. This can help you avoid passing money into your estate that will be immediately taxable. If children or a qualified trust are named, then distributions in many cases can be stretched out over the life of your children or the life expectancy of the oldest beneficiary named. The advantages could be tremendous due to the fact that the longer money can avoid taxes, the more it can grow.

Other Aspects of Income Tax Reporting

In addition to timing differences that give rise to deferred tax assets and liabilities, there are various other reasons why the percentage relation between a firm's reported pre-tax income and its income tax expense may differ from the federal statutory corporate tax rate, which is currently 35 percent. For this reason, firms are required to disclose the causes of any significant differences between the statutory and the effective tax rate in the footnotes to the financial statements. The effective tax rate is the reported income tax expense as a percentage of reported income before tax. Exhibit 9-6 provides an example of such a disclosure. Note that for a given firm, effective tax rates can be either above or below the federal statutory rate. Some differences between these rates may be relatively stable over time (such as state and local taxes), and other causes may vary in their effects over time (such as settlements and adjustments of prior years' taxes).

Financial Actions Task Force

Fortunately, Switzerland is not a party to the Mutual Legal Assistance Treaty (MLAT), which, incidentally, is not a treaty at all. Forty-eight countries have signed onto this agreement, which was created to help law enforcement in criminal investigations, except tax evasion cases. The most disturbing aspect of the MLAT is that it lacks regard for due process of law, which requires probable cause, an important aspect of the U.S. Constitution known as the Fourth Amendment. Here's another example of an international organization or, in this case, an international agreement overriding your well-founded U.S. constitutional rights, but then, thanks to the Patriot Act, we're losing those too.

The Adjusted Present Value Method

Our recommended approach for valuing investment projects is the adjusted present value (APV) method. The left-hand side of Exhibit 13.1 can be used to describe the APV method in a setting with corporate tax deductions for interest payments. First, one Grinblatt-Titman Financial I III. Valuing Real Assets I 13. Corporate Taxes and I I The McGraw-Hill Present Value of Financing Subsidies. The middle box in Exhibit 13.2 illustrates that the project's financing can create value for the firm. Although the reduction in corporate taxes linked to debt financing may be the most important source of value created by financing (as measured relative to the all-equity financing case), it is not the only source. For example, to lure Nissan's automobile assembly plant to Smyrna, Tennessee, the state offered debt financing at reduced rates.

Last Year Rattner Robotics Had 5 Million In Operating

ST-1 Last year Rattner Robotics had 5,000,000 in operating income (EBIT). The company had a net NETINCOME, CASH FLOW, depreciation expense of 1,000,000 and an interest expense of 1,000,000 its corporate tax rate AND EVA Was 40 percent. The company has 14,000,000 in non-interest-earning current assets and 4,000,000 in non-interest-bearing current liabilities it has 15,000,000 in net plant and equipment. It estimates that it has an after-tax cost of capital of 10 percent. Assume that Rattner's only noncash item was depreciation.

Example 132 Applying the APV Method to Value a Project

Since the project generates large tax deductions in the first two years, UT will initially finance the project exclusively with equity. However, at the start of year 3 the firm will repurchase some of its equity and borrow 2 billion to finance the project for the last two years of its life. The borrowing (and discount) rate at this time will be 8 percent per year and the corporate tax rate will be 34 percent. What is the present value of the project, given this plan for debt financing Chapter 13 Corporate Taxes and the Impact of Financing on Real Asset Valuation 471 The Discount Rate for Risky Debt Tax Shields. Most applications of the APV assume that the debt tax savings can be discounted at the risk-free rate. However, the tax savings from debt will not be risk free and should not be discounted at the risk-free rate if the firm's financing plans are flexible or if there is a chance that the firm may not be able to generate cash flows large enough to take full advantage of the...

Conch Republic Electronics

Net working capital for the PDAs will be 20 percent of sales and will occur with the timing of the cash flows for the year (i.e., there is no initial outlay for NWC). Changes in NWC will thus first occur in Year 1 with the first year's sales. Conch Republic has a 35 percent corporate tax rate and a 12 percent required return.

Example 133 Computing NPVs When the Debt Tax Shield Is Risky

The managers of the Engoleum Corporation are considering the possibility of buying new molding equipment at a cost of 100 million. The equipment is expected to generate unlevered cash flows of 20 million per year for the next 10 years. Analysts estimate that the beta of these cash flows, pUA, is close to 1 and that the expected return on the market is 13 percent. Although the risk-free rate is 5 percent, the firm's borrowing rate is 8 percent. Assume that the project adds 80 million to the firm's debt capacity for the life of the project and that the corporate tax rate is 30 percent. To calculate the present value of the debt tax shield The debt interest tax shield adds 1.92 million ( .08 x .30 x 80 million) to cash flows each year if it is fully utilized, and thus is expected to add 75 percent of this amount or 1.44 million per year. We conjecture that the beta of these tax savings is somewhat less than the beta of the firm's unlevered cash flows and probably resembles the beta of...

Integration of Tax Effects and Financial Distress Costs

Modigliani and Miller argue that the firm's value rises with leverage in the presence of corporate taxes. Because this implies that all firms should choose maximum debt, the theory does not predict the behavior of firms in the real world. Other authors have suggested that bankruptcy and related costs reduce the value of the levered firm.

Comparison of the Apv Fte and WACC Approaches

The last approach is the weighted-average-cost-of-capital (WACC) method. This technique calculates the project's after-tax cash flows assuming all-equity financing (UCF). The UCF is placed in the numerator of the capital-budgeting equation. The denominator, rWACC, is a weighted average of the cost of equity capital and the cost of debt capital. The tax advantage of debt is reflected in the denominator because the cost of debt capital is determined net of corporate tax. The numerator does not reflect debt at all.

Example 139 Calculating the Cost of Debt for Highly Levered Firms

RJR Nabisco has issued high-yield bonds to finance its LBO. Assume that the outstanding bonds currently have a 14 percent per year yield to maturity, a beta of .5, and interest payments that are tax deductible with a probability of .75. If the risk-free rate is 8 percent per year, the expected return of the market portfolio is 14 percent, and the corporate tax rate is 34 percent, what is the after-tax cost of debt to RJR Nabisco To calculate the after-tax cost of debt, note that when RJR has sufficient income to take advantage of the tax shield, it enjoys a tax savings of 4.76 percent ( 14 X .34). With .75 as the probability of utilization, the expected tax savings per dollar of debt equals 3.57 percent ( 4.76 X .75), so RJR's after-tax cost of debt is 7.43 percent ( 11 - 3.57 ).

Example 1313 Adopting Projects That Have Rates of Return Below Your Cost of Capital

GECC, a subsidiary of General Electric with a 20 CAPM-based weighted average cost of capital, leases private corporate jets. For a Gulfstream jet, it charges 500,000 per year on its 10-year lease payable at the end of each year. The cash flows associated with such leases are risk-free and once the lease is signed, it is not possible to get out of the lease. GECC is in the process of closing a deal with the management of AMD (Advanced Micro Devices) on one of these jets. AMD, which has an equity beta of one and a cost of capital equal to 12 , suddenly makes an intriguing offer. AMD offers to lease the jet for 10 years, but with an upfront payment of 3 million in lieu of the 10 separate annual payments of 500,000. What discount rate should GECC use to decide whether to accept the offer if the corporate tax rate is 50 percent and the risk-free rate is 6 percent

Example 1211 Leverage Can Decrease the Price Earnings Ratio

In Example 12.11, the debt issue decreased Gamma Feron's price earnings ratio from 12.5 to 10. If debt is default free, so that debt interest is always paid, more leverage will decrease the price earnings ratio whenever the ratio of unlevered earnings to price exceeds the yield rD on the risk-free debt. (If there had been corporate taxes in Example 12.11, the comparison would have to be made with the after-tax cost of debt, rD X (1 - tax rate).) In this case, the 8 percent ratio of unlevered earnings to price, ( 2 25), exceeds the

Example 1315 Adjusting Comparison Firm WACCs for Leverage

This extends Example 13.2, where the unlevered cost of capital for the Marriott restaurant division was found to be 10.97 percent per year when the corporate tax rate is 34 percent. Compute the WACC for Marriott's restaurant division, assuming that the division's debt capacity implies a target DIE .4 and static perpetual risk-free debt, as in the Hamada model.

Capital Structure and Dividend Policy

We consider the firm's overall capital-structure decision in Chapters 15 and 16. In general, a firm can choose any capital structure it desires common stocks, bonds, preferred stocks, and so on. How should a firm choose its capital structure Changing the capital structure of the firm changes the way the firm pays out its cash flows. Firms that borrow pay lower taxes than firms that do not. Because of corporate taxes, the value of a firm that borrows may be higher than the value of one that does not. However, with costly bankruptcy, a firm that borrows may have lower value. The combined effects of taxes and bankruptcy costs can produce an optimal capital structure.

Sources of Shareholder Value

For the stockholder, earnings are the source of future cash flows. Earnings, profits, and net incomes are the cash flows that remain after the costs of production are subtracted from the sales revenues of the firm. The costs of production include labor and material costs, interest on debt, corporate taxes, and allowances for depreciation.

Tracking Portfolios and Real Asset Valuation

3However, one practical issue of great importance, of which the reader needs to be aware, is not addressed in this chapter the issue of how corporate taxes affect the valuation of projects financed with debt. Unless the reader is valuing only equity-financed projects or projects with no corporate tax implications, we urge the study of Chapter 13, which addresses this topic.

The Effect of Leverage on a Firms WACC When There Are No Taxes

Example 13.11 The Effect of Debt on the WACC without Corporate Taxes Divided Technologies has no debt financing and has an equity beta of .5. Assume that the risk-free rate is 8 percent, the CAPM holds, the expected rate of return of the market portfolio is 14 percent, and there are no corporate taxes. If the firm can repurchase one-third of its outstanding shares and finance the repurchase by issuing risk-free debt carrying an 8 percent interest rate, what will be the effect of a debt-financed share repurchase on its WACC and cost of equity Chapter 13 Corporate Taxes and the Impact of Financing on Real Asset Valuation

Summary and Conclusions

We mentioned in the last chapter that, according to theory, firms should create all-debt capital structures under corporate taxation. Because firms generally assume moderate amounts of debt in the real world, the theory must have been missing something at that point. We point out in this chapter that costs of financial distress cause firms to restrain their issuance of debt. These costs are of two types direct and indirect. Lawyers' and accountants' fees during the bankruptcy process are examples of direct costs. We mention four examples of indirect costs 6. The results so far have ignored personal taxes. If distributions to equityholders are taxed at a lower effective personal tax rate than are interest payments, the tax advantage to debt at the corporate level is partially offset. In fact, the corporate tax advantage to debt is eliminated if

Filing Schedule C Taxes

Large-scale corporate tax preparation is beyond the scope of this chapter and the intent of this book. (After all, if you're involved in such preparation, it's likely you're not a complete idiot about finances.) But if you're involved in an entrepreneurial business, it may be helpful to know about Schedule C.

Identifying the Unlevered Cost of Capital

Chapter 11 examined how one could value a project using a risk-adjusted discount rate estimated from the stock returns of comparison firms.7 These risk-adjusted discount rates required an adjustment for the effect of leverage. However, the unlevering procedure described in Chapter 11 assumed no taxes. With corporate tax deductions for interest, the procedure for identifying a project's unlevered cost of capital is very similar to the procedure used in Chapter 11. However, the formula for unlevering the betas must be modified whenever the betas of the debt tax shields differ from the betas of unlevered assets. The formula for unlevering the equity betas of comparison firms in the presence of corporate taxes is embedded in equation (13.6) which, when reversed, reads The Marriott Example Revisited. Valuations with the risk-adjusted discount rate method typically use comparisons with traded securities. When debt tax shields exist, it is the betas and required rates of return of the...

How Debt Affects After Tax Cash Flows

If the corporate tax rate is Tc, a firm with pretax cash flows of X, which we will assume for simplicity is EBIT, and interest payments of rDD has taxable income of X - rDD and pays a corporate tax of (X - rDD)Tc. Since interest expense is tax deductible, a firm can reduce its tax liabilities and thus increase the amount it distributes to its security holders by issuing additional debt. Therefore, in the absence of personal taxes, transaction costs, and bankruptcy costs, and holding the pretax cash flow generated by the firm constant, the value-maximizing capital structure includes enough debt to eliminate the firm's tax liabilities. 7A firm can carry back the net losses in its current year as far as two years. When there is not enough income in the previous two years to allow the loss carryback, the firm can carry forward those losses for up to 20 years to offset future taxable profits. Hence, the corporate tax advantage of debt financing applies even to firms that are temporarily...

How Firms Establish Capital Structure

Chapiteau Structure

Most Corporations Have Low Debt-Asset Ratios. In fact, historically, most U.S. corporations use less debt than equity financing. Many of these corporations pay substantial amounts in taxes, and the corporate tax has been an important source of government revenue. Figures 14.3 and 14.4 show the debt-to-value ratios for U.S. industrial firms in both book and market values for the years 1988 to 1999. Notice that the debt ratios are usually less than 50 percent. Nevertheless firms pay substantial taxes. For example, corporate taxes were almost 200 billion in 1996. It is clear that corporations do not issue debt up to the point that tax shelters are completely used up.36 Figure 16.5 shows the debt-to-total-value ratios of firms in several countries in recent years. Differences in accounting procedures make these figures difficult to interpret. However, the debt ratios of U.S. and Canadian firms are the lowest. In all of the countries, firms have debt ratios considerably less than 100...

Expected Return Dividends and Personal Taxes

The material presented so far in this chapter can properly be called a discussion of dividend policy. That is, it is concerned with the level of dividends chosen by a firm. A related, but distinctly different, question is, What is the relationship between the expected return on a security and its dividend yield To answer this question, we consider an extreme situation where dividends are taxed as ordinary income and capital gains are not taxed. Corporate taxes are ignored. Does the above example suggest that corporate managers should avoid paying dividends One might think so at first glance, because firm g sells at a higher price at date 0 than does firm d. However, by deferring a potential 20 dividend, firm d might increase its stock price at date 0 by far less than 20. For example, this is likely to be the case if firm d's best use for its cash is to pay 20 for a company whose market price is far below 20. Moreover, our previous discussion showed that deferment of dividends to...

Example 145 Personal Tax Preferences for Holding Debt versus Equity Securities

The Analysis When Investors Have Identical Tax Rates. To understand how personal taxes affect the choice between issuing debt and issuing equity, consider the total cash flows distributed to the firm's debt and equity investors. For simplicity, assume that the personal tax rates, TD and TE, do not differ across investors. The after-tax cash flow C that these investors receive is determined by corporate taxes, personal taxes, and the way in which the firm is financed. Exhibit 14.4 illustrates this as a stream of cash that starts with all the firm's realized pretax cash flows X and branches out into smaller streams that reflect the cash distributed to debt and equity holders, and to the government in the form of taxes. To keep this illustration simple, Exhibit 14.4 assumes that the firm pays out all its earnings and that its earnings before interest and taxes (EBIT) exceed its promised interest payment, rDD. The upper branch of the stream carries the pretax cash that flows to the equity...

Know Your Time Horizon

The lesson is clear look at a longer time horizon for your investment dollars. Realize that you or your spouse may live many more years. Make sure there are adequate funds to support you. Chapter 6 reveals why you want to avoid taxes and allow your funds to grow as quickly as possible in tax-favored vehicles.

Direct Bankruptcy Costs

These direct bankruptcy costs are a disincentive to debt financing. If a firm goes bankrupt, then, suddenly, a piece of the firm disappears. This amounts to a bankruptcy tax. So a firm faces a trade-off borrowing saves a firm money on its corporate taxes, but the more a firm borrows, the more likely it is that the firm will become bankrupt and have to pay the bankruptcy tax.

Qualified Intermediaries

This does not seem to be a problem for the U.S. government, possibly because these investments may not necessarily be purely for tax reasons. And offshore investments would be more difficult to control, since the investments are outside the United States. But American investors have also begun investing back into U.S. markets for the purpose of letting their profits rest offshore in a low-or no-tax haven to avoid capital gains taxes. What other reason would you have for investing in this manner when you could just open an account with Charles Schwab I suppose you could claim asset protection, but the Internal Revenue Service (IRS) clearly interprets it as an attempt to evade taxes. Well, the IRS does not take kindly to being cheated by taxpayers out of their hard-earned revenues. The IRS has devised the Qualified Intermediary (QI) to uncover those investors who are making it a practice of investing back into the United States anonymously while simultaneously not...

Adjusted Present Value APV Theory

Computing tax savings, given the debt level. APV decomposes the value of the firm into two components the value of the firm if it were all equity-financed and fully taxed, plus a tax subsidy for each dollar that can be declared as interest rather than as dividend. In our example from Table 18.1, 280 profit minus 24 in corporate taxes for a net of 256 is the expected cash flow of the firm if it is 100 equity financed. The APV method then adds the tax subsidy depending on the firm's debt ratio. For example, High interest payments If the firm could have interest payments of 80, the IRS would believe that the firm had not earned a penny. Therefore, the owners could keep an extra 24 above the 256 all-taxed scenario next year. Normal interest payments If the firm has interest payments of, say 19, the IRS would see 280 - 19 261 in return minus 200 investment cost for a net return of 61. The IRS would therefore collect 30 - 61 18.30, which is 5.70 less than the 24 that the IRS would have...

Paying Corporate Income Taxes

The IRS is very specific about when corporate taxes are due The 15th day of the third month after the close of the fiscal year. If your fiscal year ends December 31, the corporate income taxes are due March 15. If your fiscal year ends August 31, taxes are due November 15.

Chapter Review and Self Test Problems

17.3 M& M Proposition I (with corporate taxes) Gypco expects an EBIT of 10,000 every year forever. Gypco can borrow at 7 percent. Suppose Gypco currently has no debt and its cost of equity is 17 percent. If the corporate tax rate is 35 percent, what is the value of the firm What will the value be if Gypco borrows 15,000 and uses the proceeds to repurchase stock

The Risk of the Components of the Firms Balance Sheet with Tax Deductible Debt Interest

Exhibit 13.1 Balance Sheet for a Firm with Leverage When Debt Interest Is Corporate Tax Deductible Exhibit 13.1 Balance Sheet for a Firm with Leverage When Debt Interest Is Corporate Tax Deductible presents the two sides of the balance sheet of a firm for which there is a corporate tax deduction for debt interest payments, but no personal taxes. Exhibit 13.1 illustrates that typically, the assets of the firm contain two components, one associated directly with the firm's operations and the other an indirect asset associated with a financing subsidy. The former component, the unlevered assets (UA), is defined as the present value of the unlevered cash flows the other component, the debt tax shield (TX), is the present value of the financing subsidy (that is, the present value of the debt-interest deduction for all corporate profits taxes federal, state, and city). The more debt the firm has, the bigger this tax shield. Note that the two sides of the balance sheet must add up to the...

Understanding The Issues

Company S is an 80 -owned subsidiary of Company P. On January 1, 20X1, Company P sold equipment to Company S at a 50,000 profit. Assume a 30 corporate tax rate and an 80 dividend exclusion. The equipment has a 5-year life. The question is, would taxes have been paid on this profit and what adjustments (if needed) for the tax would be made, if

Example 152 The Effective Tax Rate on MGIs Profits

MGI earned 100 million in pretax profits in 1996. Its corporate tax rate is 34 percent. Joe Gecko, who owns 10 percent of the firm's shares, has a personal marginal tax rate of 33.33 percent. From Gecko's perspective, what is the effective tax rate on MGI's profits if its entire after-tax profits are distributed as a dividend Answer MGI will pay 34 million in corporate taxes and distribute 66 million to shareholders in the form of a dividend. Gecko thus receives 6.6 million in dividends and pays 2.2 million in personal taxes, leaving him with 4.4 million after taxes from his 10 million share of the firm's pretax profits. From Gecko's perspective, the effective tax rate on corporate profits is 56 percent ( 3.4 million + 2.2 million) 10 million .

Comparison of the Classical and Imputation Tax Systems

A number of countries outside the United States have changed their tax systems to eliminate the double taxation of corporate profits. Greece and Norway, for example, allow dividends to be deducted from corporate taxes and thus treat dividends and interest payments symmetrically. Australia, Canada, France, Germany, Italy, and the United Kingdom have introduced imputation systems, under which investors who receive taxable dividends get a tax credit for part or all of the taxes paid by the corporation. This tax credit at least partly offsets the personal taxes these investors must pay on dividend income.

Reliable Gearing Currently Is All-equity-financed

Debt interest is a tax-deductible expense. Thus borrowing creates an interest tax shield, which equals the marginal corporate tax rate Tc times the interest payment rdebt x D. Future interest tax shields are usually valued by discounting at the borrowing rate rdebt. In the special case of permanent debt, 12. Tax Shields. Now suppose that the corporate tax is Tc .35. Demonstrate that when River Cruises borrows the 250,000, the combined after-tax income of its debtholders and equi-tyholders increases (compared to all-equity financing) by 35 percent of the firm's interest expense regardless of the state of the economy. Assume that MM's theory holds except for taxes. There is no growth and the 40 of debt is expected to be permanent. Assume a 35 percent corporate tax rate. 28. Trade-Off Theory. Smoke and Mirrors currently has EBIT of 25,000 and is all-equity financed. EBIT is expected to stay at this level indefinitely. The firm pays corporate taxes equal to 35 percent of taxable income....

Realworld Factors Favoring A Low Payout

This tax disadvantage of dividends doesn't necessarily lead to a policy of paying no dividends. Suppose a firm has some excess cash after selecting all positive NPV projects (this type of excess cash is frequently referred to as free cash flow). The firm is considering two mutually exclusive uses of the excess cash (1) pay dividends or (2) retain the excess cash for investment in securities. The correct dividend policy will depend upon the individual tax rate and the corporate tax rate. To see why, suppose the Regional Electric Company has 1,000 in extra cash. It can retain the cash and invest it in Treasury bills yielding 10 percent, or it can pay the cash to shareholders as a dividend. Shareholders can also invest in Treasury bills with the same yield. The corporate tax rate is 34 percent, and the individual tax rate is 28 percent. What is the amount of cash that investors will have after five years under each policy If Regional Electric Company retains the cash, invests in Treasury...

The Role of Personal Income Taxes and Clientele Effects

As a CFO, you need to know how your investors' personal income taxes can influence the optimal corporate capital structure. This chapter explains that there is a subtle interplay between personal and corporate taxes, which creates both investor clienteles and firm clienteles

The Principle Should Be Joint Tax Avoidance

The main point of this entire chapter is that managers, who want to best represent corporate owners, should consider not only their own corporate income taxes, but also other issues affecting their investors. But let us start with personal income taxes. To understand the logic, pretend that you are the owner of a corner shop (the corporation) and you are also its manager. Do you care whether the IRS taxes you right at the cash register of your corporate business, or taxes you personally when you move the cash from the corporate register into your personal pocket Or do you care how much you can ultimately put into your pocket The finance premise is that you care only about the money in your pocket that you have left over after Uncle Sam has had his dip from both. You want to reduce the net tax obligation both at the cash register (the corporate tax) and at your personal pocket (the personal tax). Corporate investors are no different from your corner shop. They really care only about...

Consider A Single Period Binomial Setting Where The Riskless Interest Rate Is Zero And There Are No Taxes. A Firm

Assume that the real riskless interest rate is zero and the corporate tax rate is 33 percent. IGWT Industries can borrow at the riskless interest rate. It will have an inflation-adjusted EBIT next year of 200 million. It would like to borrow 50 million today. Its only deductions will be interest payments (if any). 14.5. As owner of 10 percent of ABC Industries, you have control of its capital structure decision. The current corporate tax rate is 34 percent and your personal tax rate is 31 percent. Assume that the returns to stockholders accrue as nontaxable capital gains. ABC currently has no debt and can finance the repurchase of 10 percent of its outstanding shares by borrowing 100 million at the risk free rate of 10 percent. The AAA (taxfree) municipal bond rate is 8 percent. If you hold your 10 percent of the firm constant and buy the municipal bonds, what is your annual after-tax gain from this transaction 14.7. Assume the corporate tax rate is 50 percent, AAA corporate...

Dividends Taxes and Investment Distortions

The Investment Policy Favored by Tax-Paying Shareholders. Assume that you own shares in Continental Corporation and have a marginal tax rate on personal income of 50 percent. Suppose that Continental Corporation must decide whether to pay out an additional 1 million in dividends or to retain the earnings for internal investment. As the holder of 10 percent of the outstanding shares, you have a major say in the decision and need to consider the possibilities seriously. Your advisors calculate that over the next five years the firm will earn 6 percent after corporate taxes with certainty on the 1 million and that these earnings will be distributed to the shareholders in addition to the dividends they would have received otherwise. At the end of the five years, the 1 million retained this year will be distributed to shareholders. In essence, the choice for shareholders is whether to defer the 1 million dividend for five years and receive, as compensation for this deferral, additional...

Example 155 The Effect of Personal Taxes on Corporate Investments

GT Associates can earn 15 percent before taxes on its investments. However, being taxed at a 33.33 percent rate on corporate income, it earns only 10 percent after taxes. Equity investments that exactly track the future cash flows of GT's projects have a pretax rate of return of 10 percent and are taxed at a 20 percent personal capital gains tax rate at the time the gain is realized. The 10 percent return on the tracking portfolio is GT's cost of capital (see Chapters 11 and 13), as it represents the financial market's alternative to an investment in the real assets of GT. GT has an investment opportunity that costs 125 million and earns 10 percent, after taking out corporate taxes, which is exactly the firm's cost of capital. Describe how GT would assess the profitability of this project, (1) in the case where GT must raise outside equity to fund the project and (2) where it has internally generated cash that it would otherwise distribute to its shareholders. Answer (1) Observe that...

Personal Taxes Payout Policy and Capital Structure

The arguments in the last section can be extended to show that the firm will want to fund new investment with retained earnings rather than debt if the firm's shareholders' personal tax rate on debt exceeds the corporate tax rate. This can be seen if we view the investment illustrated in Exhibit 15.5 as paying off some of the firm's Bill Gates, founder and CEO of Microsoft, recognizes that there is a tax gain from debt financing and that Microsoft can increase the firm's leverage, either by repurchasing shares or by paying a dividend, and funding more of the firm's investment needs from debt securities without running any significant risk of bankruptcy. This would increase firm value by lowering its corporate tax bite. Gates currently owns about 20 percent of the company's shares. Assume that he would like to retain this percentage of ownership. The corporate tax rate is currently 35 percent and Gates's personal tax rate is 40 percent on ordinary income and 20 percent on capital...

Example 137 Computing a Weighted Average Cost of Capital

Chang believes that the required rate of return on ExMart equity when it is 50 percent levered will be 12 percent per year. Since ExMart is a very stable business, it will be able to borrow at the risk-free rate of 8 percent per year. If the marginal corporate tax rate is 25 percent, what is the WACC for ExMart Chapter 13 Corporate Taxes and the Impact of Financing on Real Asset Valuation 477

Investing excess funds

Portfolio management There are at least three types of portfolio management available to international cash managers. First, MNCs can optimize cash flows worldwide with a zero portfolio. All excess funds of subsidiaries are remitted to the parent and then used to pay the parent's short-term debts. Second, they can centralize cash management in third countries, such as tax-haven countries, and invest funds in marketable securities. Third, they can centralize cash management at headquarters, with subsidiaries holding only minimum amounts of cash for transaction purposes.

The Interest Tax Shield

The tax saving attained by a firm from the tax deductibility of interest expense What we are seeing is that the total cash flow to L is 24 more. This occurs because L's tax bill (which is a cash ouiflow) is 24 less. The fact that interest is deductible for tax purposes has generated a tax saving equal to the interest payment ( 80) multiplied by the corporate tax rate (30 percent) 80 X .30 S24. We call this tax saving the interest tax shield.

The Static Theory of Capital Structure

The static theory is illustrated in Figure 13.5, which plots the value of the iirm, VL, against the amount of debt, D. In Figure 13.5, wc have drawn lines corresponding to three different stories. The first is M& M Proposition I with no taxes. This is the horizontal line extending from Vu, and it indicates that the value of the firm is unaffected by its capital structure. The second case, M& M Proposition I with corporate taxes, is given by the upward-sloping straight line. These two cases are exactly the same as the ones we previously illustrated in Figure 13.4.

Optimal Capital Structure and the Cost of Capital

To finish our story, we include the impact of bankruptcy, or financial distress, costs lo get Case III. As is shown in the top part of Figure 13.6. the value of (he firm will not be as large as we previously indicated. The reason is that the firm's value is reduced by the present value of the potential future bankruptcy costs. These costs grow as the firm borrows more and more, and they eventually overwhelm the tax advantage of debt financing. The optimal capital structure occurs at D*, the point at which the tax saving from an additional dollar in debt financing is exactly balanced by the increased bankruptcy costs associated with the additional borrowing. This is the essence of the static theory of capital structure.

Estimating Cash Taxes

In emerging markets, an accurate assessment of cash taxes can be quite challenging. An example is Brazil, which has had large and frequent changes to the tax code. In 1996, Brazil eliminated inflation accounting and reduced the corporate tax rate to 30.5 percent. In 1997, the government disallowed the deductibility of the social contribution tax, effectively increasing the tax rate to 33 percent. To make up for the loss of the tax shields that inflation accounting had generated, the government allowed companies to deduct interest on equity net of a withholding tax of 15 percent. Many other emerging markets have significant cash tax adjustments that need to be understood before you start a valuation.

Yogi Berra on the MM Proposition

With a tax rate of about 40 percent, this implies that every dollar of debt adds about 40 cents of value to the firm, and this leads to the conclusion that the optimal capital structure is virtually 100 percent debt. MM also showed that the cost of equity, rs, increases as leverage increases, but that it doesn't increase quite as fast as it would if there were no taxes. As a result, under MM with corporate taxes the WACC falls as debt is added.

Taxes And The Weightedaverage Cost Of Capital

Thus far in this section our examples have ignored taxes. Taxes are important because interest payments are deducted from income before tax is calculated. Therefore, the cost to the company of an interest payment is reduced by the amount of this tax saving. The interest rate on Geothermal's debt is rdebt 8 percent. However, with a corporate tax rate of Tc .35, the government bears 35 percent of the cost of the interest payments. The government doesn't send the firm a check for this amount, but the income tax that the firm pays is reduced by 35 percent of its interest expense.

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