1/ CORPORATE INCOME TAXES

Up to now, our reasoning was based on a tax-free world, which of course does not exist. The investor's net return can be two to five times (or more) lower than the pre-tax cash flows of an industrial investment.

It would therefore be foolhardy to ignore taxation, which forces financial managers to devote a considerable amount of their time to tax optimisation.

But we ought not go to the other extreme and concentrate solely on tax variables. All too many decisions based entirely on tax considerations lead to ridiculous outcomes, such as insufficient earnings capacity or a change in fiscal regulations. Tax deficits alone are no reason to buy a company!

In 1963, Modigliani and Miller pushed their initial demonstration further, but this time they factored in corporate income tax (but no other taxes) in an economy in which companies' financial expenses are tax-deductible, but not dividends. This is pretty much the case in most countries.

The conclusion was unmistakable: once you factor in corporate income tax, there is more incentive to use debt rather than equity financing.

Interest expenses can be deducted from the company's tax base, so that creditors receive their coupon payments before they have been taxed. Dividends, on the other hand, are not deductible and are paid to shareholders after taxation.

Thus, a debt-free company with equity financing of 100, on which shareholders require a 7.5% return, will have to generate profit of at least 10.4 in order to provide the required return of 7.5 after 28% tax.

If, however, its financing is equally divided between debt at 4% interest and equity, a profit of 9.6 will be enough to satisfy shareholders despite the premium for the greater risk to shares created by the debt (i.e. 11%).

Allowing interest expenses to be deducted from companies' tax base is a kind of subsidy the state grants to companies with debt. But to benefit from this tax shield, the company must generate a profit.

A company that continually resorts to debt will benefit from tax savings that must be factored into its enterprise value.

Take, for example, a company with an enterprise value of 100, of which 50 is financed by equity and 50 by perpetual debt at 4%. Interest expenses will be 2 each year. Assuming a 28% tax rate and an operating profit of more than 2 regardless of the year under review (an amount sufficient to benefit from the tax savings), the tax savings will be 28% × 2, or 0.56 for each year. The present value of this perpetual bond increases shareholders' wealth by 0.56 / 14.5% = 3.9 if 14.5% is the cost of equity. Taking the tax savings into account increases the value of equity by 8% to 53.9 (50 + 3.9).

TAX SAVINGS AS A PERCENTAGE OF EQUITY

The value of a levered company is equal to what it would be without the debt, plus the amount of savings generated by the tax shield.³

The question now is what discount rate should be applied to the tax savings generated by the deductibility of interest expense? Should we use the cost of debt, as Modigliani and Miller did in their article in 1963, the weighted average cost of capital or the cost of equity?

Using the cost of debt is justified if we are certain that the tax savings are permanent. In addition, this allows us to use a particularly simple formula:

Nevertheless, there are good reasons to prefer to discount the savings at the cost of equity, since it would be difficult to assume that the company will continually carry the same debt, generate profits and be taxed at the same rate. As the tax savings accrue to the shareholders, so should it be reasonable to discount them at the rate of return required by those shareholders.

Bear in mind that these tax savings only apply if the company has sufficient earnings power and does not benefit from any other tax exemptions, such as tax-loss carryforwards.

2/ COSTS OF FINANCIAL DISTRESS

We have seen that the more debt a firm carries, the greater the risk that it will not be able to meet its commitments. If the worst comes to the worst, the company files for bankruptcy, which in the final analysis simply means that assets are reallocated to more profitable ventures.

For investors with a well-diversified portfolio, the cost of the bankruptcy will theoretically be nil, since when a company is discontinued, its assets (market share, customers, factories, etc.) are taken over by others who will manage them better. One person's loss is another person's gain! If the investor has a diversified portfolio, the capital losses will be offset by other capital gains.

In practice, however, markets are not perfect and we all know that even if bankruptcies are a means of reallocating resources, they carry a very real cost to those involved. These include:

• Direct costs: redundancy payments, legal fees, administrative costs, shareholders' efforts to receive a liquidation dividend.
• Indirect costs: order cancellations (for fear they will not be honoured), less trade credit (because it may not be repaid), reduced productivity (strikes, underutilisation of production capacity), no more access to financing (even for profitable projects); as well as incalculable human costs.

One could say that bankruptcy occurs when shareholders refuse to inject more funds once they have concluded that their initial investment is lost. In essence, they are handing the company over to its creditors, who then become the new shareholders. The creditors bear all the costs of the malfunctioning company, thus further reducing their chances of getting repaid.

Even without going to the extremes of bankruptcy, a highly levered company in financial distress faces certain dysfunctions that reduce its value. It may have to cut back on R&D expenditure, maintenance, training or marketing expenses in order to meet its debt payments and will find it increasingly difficult to raise new funding, even for profitable investment projects.

After factoring all these costs into the equation, we can say that:

or, as illustrated by the following figure:

Because of the tax deduction, debt can, in fact, create value. A levered company may be worth more than if it had only equity financing. However, there are two good reasons why this advantage should not be overstated. Firstly, when a company with excessive debt is in financial distress, its tax advantage disappears, since it no longer generates sufficient profits. Secondly, the high debt level may lead to restructuring costs and lost investment opportunities if financing is no longer available. As a result, debt should not exceed a certain level.

In 2000, Graham found that the value of the tax advantage of interest expenses is around 9.7%, and it goes down to 4.3% if personal taxation of investors is also considered. Almeida and Philippon (2007) have, on the other hand, estimated the bankruptcy costs; they believe the right percentage is around 4.5% – in brief, it seems that one effect “perfectly” compensates the other. More recent works quoted in the bibliography found similar results.

In fact, Modigliani and Miller's theory states the obvious: all economic players want to reduce their tax charge! A word of caution, however. Corporate managers who focus too narrowly on reducing tax charges may end up making the wrong decisions.

3/ INTRODUCING PERSONAL TAXES, A MAJOR IMPROVEMENT TO THE PREVIOUS REASONING

In 1977, Miller released a new study in which he revisited the observation made with Modigliani in 1958 that there is no one optimal capital structure. This time, however, he factored in both corporate and personal taxes.

Miller claimed that the taxes paid by investors can cancel out those paid by companies. This would mean that the value of the firm would remain the same regardless of the type of financing used. Again, there should be no optimal capital structure.

Miller based his argument on the assumption that equity income is not taxed, and that the tax rate on interest income is marginally equal to the corporate tax rate. In other words, the tax advantage of debt at the level of the company is neutralised by the tax advantage of equity at the level of the investor.

Who benefits from taxation? No research has shown that the tax advantage of debt is not shared equally between creditor and debtor. In recent years, tax reforms have led to the disappearance of tax friction and thus the debt advantage is tending to disappear. For certain types of investors, there is therefore no longer any tax friction when collecting their income, which is fundamental.

Say a company has an enterprise value of 1,000. Regardless of its type of financing, investors require a 7.5% return after corporate and personal income taxes. Bear in mind that this rate is not comparable with that determined by the CAPM (r _F + β × (r _M − r _F)), which is calculated before personal taxation.

Let's take a country where (realistically) the main tax rates are:

• corporate tax: 28.4%;
• tax on dividends: 17.2%;
• tax on interest income: 30%.

Now let us assume that the company has an operating profit of 135. This corresponds to a cost of equity of 8% if it is entirely equity-financed.

The net return of the investor, who is both shareholder and creditor of the firm, can be calculated depending on whether net debt represents 0%, 33.3%, 100% or three times the amount of equity.

The value created by debt must thus be measured in terms of the increase in net income for investors (shareholders and creditors). Our example shows that flows do not increase significantly even when the debt level is particularly high.

Using the table below, we can even see that in certain countries, such as the UK, the tax savings on corporate debt are more than offset by the personal taxes levied.

TAX RATES IN VARIOUS COUNTRIES (%)

Bear in mind, too, that companies do not always use the tax advantages of debt since there are other options, such as accelerated depreciation, provisions, etc.

4/ LIMITS TO THE DEDUCTIBILITY OF INTEREST AND NOTIONAL INTEREST, THE THIRD LIMIT

In a certain number of jurisdictions, governments have introduced mechanisms to rebalance taxation of revenues from capital gains and debt.

These measures can take the form of a limitation of the deductibility of interest. For example in Belgium, France, Germany, Italy, Spain, the UK and USA, interest is deductible only up to 30% of EBITDA.

In some countries, to make equity financing more attractive, firms can deduct notional interest computed on equity from taxable income. This is the case in Belgium, Brazil and Italy.

1/ DEBT AS A MEANS OF CONTROLLING CORPORATE MANAGERS

Now let us examine the interests of non-shareholder executives. They may be tempted to shun debt in order to avoid the corresponding constraints, such as a higher breakeven threshold, interest payments and principal repayments. Corporate managers are highly risk averse and their natural inclination is to accumulate cash rather than resort to debt to finance investments. Debt financing avoids this trap, since the debt repayment prevents surplus cash from accumulating.

Shareholders encourage debt as well, because it stimulates performance. The more debt a company has, the higher its risk. In the event of financial difficulties, corporate executives may lose their jobs and the attendant compensation package and remuneration in kind. This threat is considered to be sufficiently dissuasive to encourage sound management, generating optimal liquidity to service the debt and engage in profitable investments.

Shareholders are keen to leverage the firm as debt is an efficient tool to put managers under pressure and hence solve agency issues.

Given that the parameters of debt are reflected in a company's cash situation while equity financing translates into capital gains or losses at shareholder level, management will be particularly intent on the success of its debt-financed investment projects. This is another, indirect, limitation of the perfect markets theory: since the various forms of financing do not offer the same incentives to corporate executives, financing does indeed influence the choice of investment.

This would indicate that a levered company is more flexible and responsive than an unlevered company. This hypothesis was tested and proven by Ofek, who showed that the more debt they carry, the faster listed US companies react to a crisis, by filing for bankruptcy, curtailing dividend payouts or reducing the payroll.

Debt is thus an internal means of controlling management preferred by shareholders. In Chapter 45 we shall see that another is the threat of a takeover bid.

However, the use of debt has its limits. When a group's corporate structure becomes totally unbalanced, debt no longer acts as an incentive for management. On the contrary, the corporate manager will be tempted to continue expanding via debt until the group has become too big to fail, like RBS, Fortis, AIG, Citi, etc., until the concept of “too big to fail” is tested (Lehman Brothers). This risk is called “moral hazard”.

2/ LBOS: THIS LOGIC PUSHED TO THE EXTREME

An LBO (or Leveraged Buy-Out, see Chapter 47) is the acquisition, generally by management (MBO), of all of a company's shares using largely borrowed funds. It becomes a leveraged buildup if it then uses debt to buy other companies in order to increase its standing in the sector. It is generally thought that the purpose of the funds devoted to LBOs is to use accounting leverage to obtain better returns. In fact, the success of LBOs cannot be attributed to accounting leverage, since we have already seen that this alone does not create value.

The real reason for the success of LBOs is that, when it has a stake in the company, management is far more committed to making the company a success. With management most often holding a share of the equity, resource allocation will be designed to benefit shareholders. Executives have a two-fold incentive: to enhance their existing or future stake in the capital and to safeguard their jobs and reputation by ensuring that the company does not go broke. It thus becomes a classic case of the carrot and the stick!

Mature, highly profitable companies with few investments to make are the most likely candidates for an LBO. Jensen (1986) demonstrated that, in the absence of heavy debt, the executives of such companies will be strongly tempted to use the substantial free cash flow to grow to the detriment of profits by overinvesting or diversifying into other businesses, two strategies that destroy value.