13.2 Capital Structure - With Taxation

Question 1

What is the taxation effect

Answer 1

• Interest payments are deductible from tax
• Geared companies need to pay interest
  o This assumes a tax system where this is the case
  o Therefore bond holders escape taxation at a corporate level

Question 2

How does a world of tax produce extra returns based on gearing

Answer 2

• Gearing in a world of tax produces extra cash inflows for shareholders
• Risk does not change
• Therefore, gear your company as it produces extra returns
• These extra cashflows come from debt interest

Question 3

What is a tax shield

Answer 3

Additional earnings due to tax
Dt = Interest × Tax rate
Dt = (Debt × cost of debt) × Tax rate
Dt = (D × KD) × t

Question 4

What should the relative value of a geared and ungeared company be

Answer 4

The value of a geared company should be higher than that of an equivalent ungeared company
VG = VU + Dt

Question 5

What is the implication of increasing company value with gearing in a world of tax

Answer 5

• Says that companies should keep increasing debt as it increases shareholder wealth
• However this is not the case as it assumes debt as a perpetuity and a companies ability to service this changes over time
• Also requires that the company has sufficient profits for the tax shield to be taken out of (no benefit if loss making)
• Also there are some rules about only being able to deduct 30% of EBIT as finance expenses

Question 6

Explaining overall costs of capital with tax

Answer 6

Formals are too complex to put on here but need to be able to explain:
Traditionalist
Shows that the overall cost of capital is equal to the return demanded by the shareholders times the proportion of equity. Plus, the debt less tax times the proportion of debt
MM
Says that the overall cost of capital is the same as the cost of capital of an ungeared company in a world of tax less the tax shield
This formula separates out the business and finance risks