14 Capital Structure - The Personal Taxation Effect and Consideration of Financial Distress Flashcards
Is the rate of corporation tax and personal tax the same
- The corporation tax and personal tax rates are often not the same
- There are also different types of personal taxes at different rates
- Income, capital gains
What is the personal tax rate of shareholderes
The shareholder roster of any large corporation is likely to include tax-exempt investors (such as pension funds or university endowments) as well as millionaires and maybe a billionaire or two. All possible tax brackets will be mixed together
What is the overall tax rate of shareholders
- The new tax rate might be higher or lower than the rate of corporation tax used across prior models
- Therefore, this can either increase or decrease the tax shield
What is the Return on equity considering personal tax
- Dividend income + Capital gains
- If after tax income is distributed
o Then have to pay income tax - If after tax income is retained
o Then expect to be reinvested and value of company should grow
o Then on realisation of shares will have to pay capital gains - Shows how not only the tax rate impacts investors but also the company’s dividend policy
How do you donate the average effective personal tax rate of equity holders
For any one company, we could denote the average effective personal tax rate of its shareholders as tE
How do you donate the average effective personal tax rate of debt holders
- Debt holders pay tax on the interest at their marginal income tax rate
- Again, for any one company we could denote the averages effective personal tax rate of its debt holders as tD
How does MM break down with financial distress
- Following MM, you should increase gearing continually as it will increase the value of the firm
- MM assumed no change to new debt securities as the company borrowed more
o If debt is certain it is risk free
o Then shareholders are bearing the financial risk, not the lenders - But this is not the case as the amount of cashflow needed to service the debt increases so does the risk of default
- So a greater return is demanded
- Debt is unlikely to remain risk free throughout all levels of gearing there may come a point where the level of interest commitments puts the company at risk of insolvency.
What are the costs of financial distress
- Following MM, as you increase gearing to increase the value of the company
o As tax shield increases - There is a counter force of financial distress that drives it down
o As risk of liquidity problems increases
o And costs of fire sales of assets, liquidation fees
What is financial distress
- If there is a risk of default on debt the debt holders would have to be offered higher rates of interest to compensate for this risk
- In addition, if the company did default, the debt holders could force the company into liquidation, in order to recover their money through the sale of secured assets
- This would involve the company in other costs: fees to be paid, not least to the liquidator/receiver.
- A forced sale may likely mean that the amount realised on the sale of assets will not be equal to their economic value, etc
What is the value of a geared company with financial distress
VG = VU + Dt - PV(Financial Distress)
* Dt representing the tax shield which is the present value of the tax savings resulting from debt financing.
* A company only saves tax if it has taxable income I f the company is making losses, it will not have taxable income.
* Possible ‘exhaustion of the tax shield’
How does MM with financial distress compare with the traditionalists
- This is not dissimilar to the traditional view!
o The difference, in theory, is that, with the extended MM view, it is quantifiable, while, with the traditional view, it is all rather intuitive. - This shows an optimal turning point for gearing ratio
- The risk of incurring costs of financial distress has a negative effect on a firms value which offsets the value of tax relief on increasing debt levels
What are the costs of financial distress
- Even if a firm manages to avoid liquidation its relationship with; suppliers, customers, employees and creditors may be seriously damaged.
- Bankers and other lenders will tend to look upon a request for further finance from a financially distressed company with a prejudiced eye taking a safety first approach.
- The indirect costs associated with financial distress can be very high
What are other factors than financial distress that might affect gearing
- Behavioural Moral Hazard
- Inefficiencies importance of ‘signalling’
- Pecking order theory
What is the moral hazard theory
- When there is information asymmetry
o The risk taking party to a transaction knows more about its intentions than the party paying the consequences of the risk - E.G. manager taking high risk projects as a last ditch effort to save the company but if fail debt holders will suffer
- Or in financial crisis banks might think they will be bailed out so can take more high-risk decisions with taxpayer consequences
How does inefficiency and signalling affect gearing
- If the markets are inefficient then information from the companies is not captures correctly in the price
- These releases of information are called signals
- Therefore, you must make sure that the market knows and is informed, if it was efficient then it would know already
- Then it won’t overreact if you decrease dividends, provided you give the additional signals as to why you decreased them
