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Lectures Notes Financial markets first semester
Typology: Study notes
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Because companies pay taxes on their profits after interest payments are deducted, interest expenses reduce the amount of corporate tax firms must pay. This is an incentive to use debt.
The debt obligations reduced the income available to equity holders. But more importantly, the total amount available to all investors was higher with leverage:
With Leverage Without Leverage Interest paid to debt holders 430 0 Income available to equity holders 1345 1625 Available to all investors 1775 1625
Because leverage allows the firm to pay out more in total to its investors—including interest payments to debt holders—it will be able to raise more total capital initially. The gain to investors from the tax deductibility of interest payments is referred to as the interest tax shield.
The Interest Tax Shield and Firm Value
For levered firms, the gain in total cash flows to investors is the interest tax shield. Letting and represent the value of the firm with and without leverage, respectively, we have the following change to MM Proposition I in the presence of taxes:
The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt:
The Interest Tax Shield with Permanent Debt Typically, the level of future interest payments varies due to changes the firm makes in the amount of debt outstanding, changes in the interest rate on that debt, and the risk that the firm may default and fail to make an interest payment. The firm’s marginal tax rate may fluctuate due to changes in the tax code and changes in the firm’s income bracket. Many large firms have a policy of maintaining a certain amount of debt on their balance sheets. As old bonds and loans mature, new borrowing takes place. The key assumption here is that the firm maintains a fixed dollar amount of outstanding debt, rather than an amount that changes with the size of the firm.
Suppose a firm borrows debt D and keeps the debt permanently. If the firm’s marginal tax rate is τ c , and if the debt is riskless with a risk-free interest rate rf , then the interest tax shield each year is τ c * rf
The above calculation assumes the debt is risk free and the risk-free interest rate is constant. As long as the debt is fairly priced, no arbitrage implies that its market value must equal the present value of the future interest payments:
If the firm’s marginal tax rate is constant, then we have the following general formula:
The Weighted Average Cost of Capital With Taxes The tax benefit of leverage can also be expressed in terms of the weighted average cost of capital. When a firm uses debt financing, the cost of the interest it must pay is offset to some extent by the tax savings from the interest tax shield.
With tax-deductible interest, the effective after-tax borrowing rate is.
The WACC represents the effective cost of capital to the firm, after including the benefits of the interest tax shield. It is therefore lower than the pretax WACC, which is the average return paid to the firm’s investors.
The Interest Tax Shield with a Target Debt-Equity Ratio Earlier we calculated the value of the tax shield assuming the firm maintains a constant level of debt. In many cases this assumption is unrealistic—rather than maintain a constant level of debt, many firms target a specific debt-equity ratio instead. When a firm does so, the level of its debt will grow (or shrink) with the size of the firm.