## Relative Taxation of Debt and Equity

A Basic Corporate Let's discuss a simple hypothetical firm with the following parameters: Example

Investment Cost in Year 0 \$200

Before-Tax Return in Year 1 \$280

Before-Tax Net Return From Year 0 to Year 1 \$80

Corporate Income Tax Rate (t) 30%

Appropriate Cost of Capital From 0 to 1 12%

Your goal is to understand the value of this firm under different tax regimes. 18 - 1.A. Hypothetical Equal Taxation and Capital Budgeting

This short section's If the firm faces the same tax rate, regardless of how it is financed, what is its value? In the unrea|istic tax version. real world, this assumption is entirely unrealistic. (Instead, only interest payments are tax-deductible). This scenario is useful only to show that investors care about after-corporate income tax returns, not about before-corporate income tax returns.

Taxes mean that the Under this tax regime, consider financing your firm entirely with equity. With \$280 in before-after-ti^xc^erohan*"the tax earnings on the \$200 investment, you have a "before corporate income tax" internal rate before-tax rate of of return of (\$280 - \$200)/\$200 = 40%. But, with taxes to the tune of 30% on its net return return. of \$80, Uncle Sam collects \$24. Your firm's "post corporate income tax" net rate of return is therefore only (\$256 - \$200)/\$200 = 28%.

Investors get a rate of Now hold your investors' other opportunities in the economy constant. What is the influence of a change in the corporate income tax that is applicable specifically only to your firm? From the perspective of your firm, you are a "price-taker" when it comes to raising capital. You are competing with many other firms for the capital of many competitive investors. Ultimately, these investors care only about the cash that you will return to them. Let us assume that firms of your risk-class (market-beta) must offer an after-corporate income-tax rate of return of E (fFM) = 12% to attract investors. (In this chapter, we again omit time subscripts if there is little risk of confusion.) How does this matter to the rate of return that your projects must generate?

return out of a black box.

Anecdote: Special Tax Breaks and Corporate Welfare

"Special Income Tax Provisions" are tax breaks enacted by Congress for specific activities, often on behalf of a single corporation. The special income tax provisions amounts are commonly estimated to be about \$1 trillion a year—more than the total amount of federal discretionary spending! These provisions are a main reason why corporations—large corporations, really—have paid less and less in income taxes relative to the rest of the population and relative to other OECD countries. In 1965, corporate income taxes were 4.1% of U.S. GDP; in 2000, about 2.5%; in 2002, about 1.5%. And, for comparison to the 1.5% U.S. tax rate, in 2000, Germany's rate was 1.8%, Canada's rate 4.0%.

It would be wonderful if the low U.S. corporate income tax rate would attract businesses to locate into the United States and to create jobs. Alas, because the low effective corporate income tax rates come about through strange corporate tax shelters (often through relocation of headquarters into foreign countries), the United States often ends up with the worst of both worlds: both incentives for companies to move out of the United States and low corporate income tax receipts. The only president in recent history to buck the trend may have been Ronald Reagan, who slashed both the corporate income tax and the ability of companies to circumvent it. Source: "Testimony of Robert S. McIntyre" (www.ctj.org), Director of "Citizens for Tax Justice."

Your investor-owners really do not care what happens inside the firm, only what your firm can pay them in the end. It is all the same to them

• if your projects earn 12% before-tax and you manage to avoid all corporate income taxes;

• or if your projects earns 24% but you have to pay half of it in corporate income taxes;

• or if your projects earn 600% of which 98% is confiscated by the government (1 + 600% ■ (1 - 98%) = 1 + 12%).

• or if your projects face a 30% corporate tax rate, and you earn 17.14% in before-tax rate of return in order to be able to offer investors 12% in actual rate of return. (Check this: an investment of \$100 that turns into \$117.14 has to pay Uncle Sam 30% in taxes on income of \$17.14 for a total income tax of \$5.14, which leaves the firm \$112 to return to its investors after the corporate income tax is paid.)

The NPV formula is well equipped to handle corporate income taxes. However, as already explained in Chapter 6, you must calculate the present value using after-tax quantities in both the numerator and denominator. For example, the "\$280 before-corporate-income-tax" firm, with its 12% required after-corporate-income tax cost of capital, has a PV of

Projects with more tax liability must create more value before tax to be on equal footing.

Investors demand a certain rate of return, regardless of how the firm gets there.

There are some simple mistakes you must avoid here. You cannot usually find the same result if you work with pre-tax cash flows and pre-tax required rates of returns. And you would definitely ge a very wrong result if you used post-tax expected cash flows and then compared them to a cost of capital obtained from investments that have not yet been taxed at the corporate level.

Q18.1 Assume a 30% corporate income tax. Show that a project that returns 17.13% pre-corporate income tax would have a negative NPV if it cost \$100 today and if the appropriate after-tax cost of capital is 12%.

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