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So:
Raising debt does not create value (i.e., you cannot create value by borrowing and sitting on
the excess cash).
It creates value relative to raising the same amount in equity.
Hence, value is created by the tax shield when you:
o Finance an investment with debt rather than equity
o Undertake a recapitalization (i.e. fnancial transaction in which some equity is retired
and replaced with debt).
If we issue debt and invest in fnancial asset then we are taxed and so, there is a problem that
this offset each other loss the beneft of debt
THE TAX COST OF EXCESS CASH
Excess cash:
o Not useful to run operations (hard to pin down)
o Invested in fnancial assets
o It is like a negative debt for the company
o Net debt = Debt – Cash
So, it comes with a negative tax shield.
In conclusion:
o Tax shield of debt matters a lot
o And how this fnancing choice affects the government’s bite of the corporate pie?
It is standard to use t*D for the MV of debt’s tax break
o Caveats (warning):
Not all frms face full marginal tax rate and it is defnitely not ok for non
taxpaying companies TLCF
Personal taxes
TAX-LOSS CARRY FORWARDS (TLCF)
This answer how company not paying tax.
In this case, debt is not attractive.
Typically, losses in a given year can be carried forward (TLCF) against taxable income for
several tax years.
Firms with large TLCFs may not exhaust them for a number of years while they return to
proftability: in the meanwhile, they pay no taxes.
These frms cannot utilize tax shields from existing or new debt: marginal tax rate is zero.
More TLCF debt fnancing less attractive
So, the loss is carried forward so you do not need to pay taxes for few years in the future.
PERSONAL TAXES
Investors’ return from debt and equity are taxed differently.
Classical Tax Systems (e.g., US)
o Interest and dividends are taxed as ordinary income
o Capital gains are taxed at a lower rate
o Capital gains can be deferred (contrary to dividends and interest)
So, from the perspective of individual investors’ personal taxes, equity may be preferred to
debt.
However, in most cases, the personal tax advantages of equity do not outweigh the corporate
tax advantages of debt.
Moreover,
o Corporations have a 70% exclusions on dividend taxation in the US
o Equity ownership is increasingly dominated by tax-exempt institutions such as pension
funds.
Thus, it is OK to ignore personal taxes from a capital structure perspective most of the time
and we’ll ignore personal taxes.
Overall, from a tax perspective, debt is preferred to equity.
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