The tax provisions provide for deduction of interest paid on debt and therefore the debt capital can increase the company’s after tax free cash flows.
and capital structure
The tax provisions provide for
deduction of interest paid on debt and therefore the debt capital can increase
the company’s after tax free cash flows. Therefore, this interest shield
increases the value of the company.
This tax advantage of debt
implies that companies will employ more debt to reduce tax liabilities and
increase value. In practice this is not always true as is evidenced from many
Companies also have non debt tax
shields like depreciation, carry forward losses, etc. This implies that
companies that have larger non debt tax shields would employ low debt as they
may not have sufficient taxable profit to have the benefit of interest
However, there is a link between
non debt tax shields and the debt tax shields because companies with higher
depreciation would tend to have higher fixed assets, which serve as collateral
Let us examine this with an example
Let us consider two companies each having operating
income of Rs.100,000 and which are similar in all respects. However the degree
of leverage employed by them differs. Company A employs no debt capital whereas
Company B has Rs.400,000 in debt capital on which it pays 12 per cent interest.
The corporate tax rate applicable
to both the companies is 30%. The income to the share holders of these two
companies is shown in the table.
Thus it is clear that combined
income of debt holders and shareholders of the leveraged firm is higher than
that of the unlevered firm
be explained by the tax shield available to the levered firm – it is equal to the interest on debt capital
multiplied by the applicable tax rate. In this case, it is Rs.48,000 X 30% =
Rs.14,400. Only this tax shield amount is the reason for the difference in the
combined income of debt holders and shareholders of the companies A and B
Hence one may arrive at
is tax deductible and, therefore, creates an interest tax subsidy.
greater the firm’s marginal tax rate the greater the value of the interest tax
value of the interest tax subsidy depends on the firm’s ability to generate
4. The more
a firm borrows the less the expected realized value of the interest tax shield.
that there are other ways to shield income from taxes, the greater these
alternative tax reducing opportunities the lower the value of the interest tax
6. Equity investors
have a tax advantage relative to debt investors, which offset the tax advantage
of debt at the corporate level.
7. Hence there is a moderate tax
advantage to debt if you can use the tax shields.
However, taxes cannot be the only factor because we
do not see companies with 100% debt.
Tags : Financial Management - CAPITAL STRUCTURE THEORIES
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