Study On Corporate Finance And Capital Structure Theory

Published Date: 02 Nov 2017

1.1 Capital Structure Theory

Nearly half a century after the seminal Modigliani and Miller (M&M) contributions by Franco Modigliani and Merton H. Miller, capital structure and dividend policy continue to be topics of great interest in the academic literature.

In a nutshell, capital structure refers to the way a company finances its assets through its chosen financial sources. Thus a company might choose to rely solely on equity financing, on mixture of equity and debt financing, or rely solely on different kinds of debts. If a combination of equity and debt is used, the company has to decide on the relative weights of the two funding sources (Marsh P., 1982).

Modigliani and Miller developed the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of corporate taxes, bankruptcy costs, and asymmetric information (to name some), and in an efficient market, the value of a company is unaffected by how that company is financed. Thus any combination of securities is as good as another. (F. Modigliani and M. H. Miller, 1958).

In this simplified view, it can be seen that without taxes and bankruptcy costs, the Weight Average Cost of Capital, often denoted by WACC should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes/benefits to the WACC. Additionally, Pinegar and Wilbricht (1989) pointed out that since there are no changes/benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price.

In practice it is believed that capital structure does matter, but it is imperative to fully understand the conditions which M&M’s theory holds so that one can understand why companies choose certain capital structures ahead of others?

1.2 Taxation and Capital Structure

Although their rational has been generally recognised, the M&M results mark a starting point instead of the end of capital structure dispute. Whilst signifying an essential irrelevance of financial decisions for firm value, M&M already refer to company taxation as an underlying principle for preferring debt to equity (Modigliani and Miller, 1958). One of the most important imperfections is the presence of taxes. In their framework of perfect capital markets, the value of an undyingly leveraged firm evolves from adding the corporate tax shield of debt to the value of an identical but unleveraged company. (Modigliani and Miller, 1963). To illustrate, suppose that the earnings before interest and taxes are €2,000 for both company Y and Z and they are alike in every respect except in leverage. Company Z has €5,000 in debt at 12 percent interest, whereas company Y has no debt. If the tax rate is 35 percent for each company, we have

Company Y

Company Z

Earnings before interest and taxes

€2000

€2000

Interest, income to debtholders

-

600

Profit before taxes

2000

1400

Taxes @35%

700

490

Income available to shareholders

1300

910

Income to debtholders plus income to shareholders

1300

1510

Thus, total income to both debt holders and stockholders is larger for levered company Z than is for unlevered company Y. The reason is that debt holders receive interest payments without the deduction of taxes at the corporate level, whereas income to stockholders is after corporate taxes have been paid. In essence, the government pays a subsidy to the levered company for the use of debt. Total income to all investors increases by the interest payment times the tax rate. In our example, this amounts to €600 x 0.35 = €210. This figure represents a tax shield that the government provides the levered company. If the debt employed by a company is permanent, the present value of the tax shield using the perpetuity formula is

Present value of tax shield =

tcrB

=

tcB

r

where tc is the corporate tax rate, r is the interest rate on the debt, and B is the market value of the debt. For company Z in our example,

Present value of tax shield = 0.35(€5,000) = €1,750.

What we are saying is that the tax shield is a thing of value and that the overall of the company will be €1,750 more if debt is employed than if the company has no debt. This increased valuation occurs because the stream of income to all investors is €210 per year discounted at 12 percent is €210/0.12 = €1,750. This implies that the risk associated with the tax shield is that of the stream of interest payments, so the appropriate discount rate is the interest rate on the debt. Thus, the value of the firm is:

Value of firm =

Value if

+

Value of

unlevered

tax shield

For our example, suppose that the equity capitalization rate for a company A, which has no debt, is 20 percent. Therefore, the value of the firm if it were unlevered would be €1,000/0.20 = €5,000. The value of the tax shield is €1,750, so the total value of company B, the levered firm, is €6,750.

We see in the above equation that the greater the amount of debt, the greater the tax shield and the grater value of the firm, all other things being equal. Thus, the original M&M proposition as subsequently adjusted for corporate taxes suggest that an optimal strategy is to take on a maximum amount of leverage. Clearly, this is not consistent with the behaviour of corporations, and alternative explanations must be sought. As we shall see, personal taxes as well as market imperfections come into play.

1.3 Corporate and Personal taxes

Atkinson and Stiglitz (1976) argue that the M&M analysis including corporate earnings taxation still leaves something of a ‘puzzle’. The expression for the value of a geared company indicates that the tax shield is equal to corporate tax rate (T) times the book value of corporate debt (B), i.e. TB. With the present Malta rate of Corporation Tax of 35 percent, for every €1 of corporate debt, the value of the company would be increased by €0.35. If such tax benefits can stem from corporate gearing, why do we find widely dispersed gearing ratios even in the same industry? And why are some of these so much lower than the M&M theory (even allowing for costs of financial distress) might suggest? According to Miller (1977), the answers to such questions lie in the interaction of the corporate taxation system with the personal taxation system, an issue omitted in the M&M analysis.

Miller’s agenda was to re-establish the irrelevance of gearing for company value thus explaining why US firms did not appear to exploit apparently highly valuable tax shields. Miller argued that if individuals and corporations can borrow at the same rate, and if individuals invest in corporate debt as well as equity, there are no advantages to corporate borrowing because corporations that borrow are simply doing what personal investors can do for themselves. Any temporary premium in the market valuation of a geared company will be quickly unwound by the usual arbitrage process. However, this presupposes that individuals also can obtain tax relief on their personal borrowing (as applies in the USA, but not generally in Malta). Intuitively, we may expect to find some benefit to corporate borrowing in Malta because tax breaks on personal borrowing are not available.

Greatly simplifying, the Miller position can be expressed by the simple expression:

Post-tax cost of debt = pre-tax cost [1-(Tc-Tp)]

Where Tc is the tax rate at which corporations enjoy relief on debt interest and Tp is the tax rate at which individuals enjoy relief on debt interest. If Tc=Tp, then there is no tax advantage of corporate debt and hence no tax shield to exploit.

Only if Tc and Tp differ is there a tax shield. Note that for Tc > Tp the tax shield is positive, and for Tc < Tp, the tax shield appears to be negative, as might apply for shareholders subject to high rates of tax.

Miller introduced a further mechanism to support the irrelevance of gearing for company value. He argued that if there is a (temporary) tax advantage relating to debt financing, this will lead firms to increase their demand for debt (i.e. increase the supply of debt instruments), thus exerting upward pressure on interest rates until the advantage of issuing further debt disappears. If the effective tax rate on equity income were zero, and personal investors paid tax on debt interest income, companies would have to compensate investors for switching from untaxed equity to taxed debt investments by a higher interest rate. This would stop when the net-of-tax cost of debt to companies equalled the cost of equity. Miller concludes that movement to capital market equilibrium would eliminate any tax advantage of debt.

1.4 The Dividend policy

According to Fama and French (1988) dividend policy is just a fancy word used to describe how large dividends a firm is paying and how the firm chooses to arrange the actual dividend payment. All dividend payments are made from the firm to the shareholder. Furthermore, firms do not have to pay any dividends, but if they decide to do so they have all the rights to choose the size of the dividend. In addition, instead of an ordinary cash dividend a firm can also choose to buy back shares. Thus we define ‘dividend policy’ as the trade-off between retaining earnings on one hand and paying out cash and issuing new shares on the other.

1.5 Dividend taxes

Taxation and especially differential rates of personal income tax, a taxation distinction between income and capital gains, and the fact that a company might have both private and corporate shareholders who are taxed under different tax regimes, form a serious capital market imperfection which interferes with the dividend irrelevancy approach. Baker and Wurgler (2004) state that the major problem with the presence of taxation is that it can interfere with the value equivalence between dividends and retained earnings. Typically, tax on capital gains is lower than tax on income from dividends. In some countries there is no tax on capital gains. Some shareholders might prefer ‘home-made dividends’ (i.e. selling shares) when the rate of Capital Gains Tax (CGT) is lower than the marginal rate of Income Tax applied to dividends. Other may prefer dividend payments because their Income Tax liability (plus any reinvestment costs) is lower than CGT payments. In addition to considerations of personal taxation, where the financial manager has little way of knowing the particular tax positions of shareholders (a major exception to this is the case of institutional investors), complications may also be imposed by the corporate tax system.

In Europe, the tax system is very distinct. Typically, taxation of company profits depends on the type of capital. The differences in the taxation of equity financing relative to debt financing are expected to have an impact on capital structure choices. With regard to equity capital, the corporate profit tax and dividend taxation at the shareholder level must be considered. In the case of debt financing, interest payments for debt capital can be deducted from taxable profits at the corporate level. However, restrictions of the interest deductibility must be considered in several countries. Moreover, taxation of interest as personal income also leads to a tax burden on debt financing. Devereux and Sorensen (2005) explain that during the considered time period from 2000 until 2008, several amendments of company tax systems took place in European countries. Therefore, sources of variation in the tax variables are changes in the corporate tax rate on the one hand (mainly tax rate cuts) and on the other hand, several amendments of personal capital income taxation. The latter include changes of personal income tax rates and reforms relating to the integration of corporate taxation into the personal income tax.

The taxation of dividends at the shareholder-level depends on the integration system of corporate taxation into personal income taxation. There are so many different tax regimes operated throughout the world that it is difficult to generalise about the effect of taxation on dividend policy. However, the following simple example captures the flavour of some of the issues.

1.6 The Classical tax regime

Under the classical tax regime, profits are taxed twice if distributed. They are taxed at corporate level (corporate tax) and in the hands of the shareholder (income tax or capital gains tax) These two tiers of tax are illustrated in Table 2.1 and 2.2, which shows the after-tax return to the shareholder if the company distributes all its income as dividends.

Table 2.1 We assume that the investors pay tax at 10%.

Operating income

100,000,000

Corporate tax @ 35%

35,000,000

After-tax income (paid out as dividends)

65,000,000

Income tax paid by investor @ 10%

6,500,000

Net income to shareholder

58,500,000

In Case 1 the total tax charge is (€35M + €6.5M) = €41.5M (or 41.5% of pre-tax earnings)

Table 2.2 We assume that the investors pay tax at 50%.

Operating income

100,000,000

Corporate tax @ 35%

35,000,000

After-tax income (paid out as dividends)

65,000,000

Income tax paid by investor @ 50%

32,500,000

Net income to shareholder

32,500,000

In Case 2 the total tax charge is (€35M + €32.5M) = €67.5M (or 67.5% of pre-tax earnings)

It looks better to retain in the second case, but the decision also depends on the rate of capital gains tax (CGT). Assume the CGT rate is 20 percent. If we also assume that the firm invests in zero NPV projects (unlikely, but a necessary assumption to strip out the effect of the investment decision), the value of the firm will have risen from €500M at start-year to €565M at end-year. The CGT payable is thus (20% x €65M) = €13M. Along with the profit tax, the total tax payable is (€35M + €13M) = €48M. Obviously, shareholders paying income tax at 50 percent would prefer retention and vice versa.

1.7 The Imputation System

Under an imputation system, the relative attractiveness of distribution and retention depends not only on the relative tax rates, but also on whether there is full or partial imputation. For instance, let us look at the tax system in Malta. Maltese company tax rate is 35%.

This effectively means that a shareholder will not be charged to tax twice on any dividends received and could even receive a refund of tax if such income falls to be taxed at a lower rate of tax in the hands of the shareholder than the rate of tax incurred by the company.

Shareholders of Maltese companies are entitled to claim refunds of tax paid in Malta by the company on income allocated to the Foreign Income Account (FIA) and Malta Taxed Account (MTA), when such income is distributed as a dividend.

6/7 refund

Shareholders are normally entitled to claim a refund of 6/7 of the tax charged to the Maltese company, subject to a maximum of the tax actually paid to the Maltese tax authorities.

5/7 refund

Where the income in question is made up of passive interest and royalties, the shareholders may claim a refund of 5/7 of the tax charged to the Maltese company, subject to a maximum of the tax actually paid to the Maltese tax authorities. Where interest and royalties have been subject to foreign tax at a rate of 5% or more, it will automatically no longer be considered passive, and therefore qualify for the 6/7 refund.

2/3 refund

Where passive income and royalties have been subject to a claim for double taxation relief, including the Flat Rate Foreign Tax Credit, the refund of 2/3 of the Malta tax charged may be applicable.

100% refund for participating holdings / participating exemption

Under the Maltese tax system, the income and capital gains derived by a Maltese registered company from a ‘participating holding’, qualifies for a full refund of the Maltese tax paid by the company when distributions are made to company shareholders.

1.8 Conclusion

The only serious challenge to those who believe that dividend policy does not matter comes from those who stress the tax consequences of a particular dividend policy. If there were no taxes, investors would have no incentive to prefer one particular group of stocks. So they would hold well-diversified portfolios that moved closely with the market. But the fact that investors pay taxes at different rates on investments income provides an incentive for them to hold different portfolios.

The higher the tax bracket a firm finds itself in, the greater the tax shielding benefit of debt will be for the corporation an the more leverage the firm should employ in its capital structure. On the other hand, firms with large tax-loss carry forwards (such as start-up firms) or high depreciation expense will have less benefit from leverage’s tax shield and will choose lower levels of debt. Moreover, the finance manager should question whether debt is the most suitable form of funding in the circumstances, keeping in mind interest rates fluctuations and duration of debt.

Therefore, the market in reality is not efficient as Modigliani & Miller (1958) depicted, where the cost of different forms of finance do not vary independently and switching from one form of financing to another does not gain anything. A variety of evidence, on the contrary, shows that the choice between equity and debt does have impact on firm’s value. Thus various finance options are considered to optimise, and theories try to explain the debt-equity trade-off.