COMM 370 - Corporate Finance

Class 15: Capital Structure with Taxes

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Class 15 – Capital Structure with Taxes
Learning objectives:
• Analyze how corporate taxes affect firm value and cost of capital.
• Demonstrate how a leveraged recapitalization works in the MM world with taxes.

Outline:
• Revisit the MM results in a world with corporate taxes and personal taxes.
• Example of a leveraged recapitalization with corporate taxes
• Discussion of recapitalizations using special dividends vs share repurchases
• Applications: Zero-Leverage, Caps on interest deductibility, and Nathan’s Famous

• Note: this is a conceptually difficult lecture that will require careful thinking!

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Debt, Corporate Taxes, and Interest Tax Shields: MM 1
• Corporate taxes – a key capital market imperfection – make financing choices value-
relevant: interest is tax deductible, so borrowing creates firm value by saving taxes.
$Million Firm U Firm L
EBIT 500 500
- Interest expense 0 -80
Taxable income 500 420
- Taxes @ 30% -150 -126
Net income 350 294
Interest paid to debt holders 0 80
Income available for equity holders 350 294
Total available to all investors 350 374
Interest tax shield (30% of interest) 0 24

• MM 1: VL = VU + PV(ITS) ; where VU = PV(FCF ; rU) and ITS = Interest Tax Shields

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MM 1 & MM 2 With Corporate Taxes & Permanent Debt
• Assume the firm maintains a permanent debt level (or fixed dollar debt):
• as loans mature, it takes new loans to repay old ones
• or issues a perpetual bond (never repays the principal and pays interest forever)

• With a fixed dollar amount of debt and constant corporate tax rate τ:
• D = PV(future interest payments)
• PV(ITS) = (τ rD D) / rD = τ D [because rITS = rD]

• MM 1: 𝑽𝑽𝑳𝑳 = 𝑽𝑽𝑼𝑼 + 𝝉𝝉 𝑫𝑫 [borrowing increases firm value]

𝑫𝑫
• MM 2: 𝒓𝒓𝑬𝑬 = 𝒓𝒓𝑼𝑼 + 𝒓𝒓𝑼𝑼 − 𝒓𝒓𝑫𝑫 𝟏𝟏 − 𝝉𝝉 [borrowing increases the cost of equity]
𝑬𝑬𝑳𝑳

• Note: in MM2, higher debt increases rE less than it does without taxes (see (1 - τ)
term); now shareholders get interest tax shields which are relatively safe.
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Corporate Taxes & WACC
Recall that with taxes, the after-tax cost of debt is rD(1 – τ), so rWACC is:

E D
rWACC = rE + rD (1 − τ)
E+D E+D

𝐄𝐄 𝐃𝐃 𝐃𝐃
rWACC = 𝐫𝐫𝐄𝐄 + 𝐫𝐫𝐃𝐃 − 𝐫𝐫𝐃𝐃 𝛕𝛕
𝐄𝐄+𝐃𝐃 𝐄𝐄+𝐃𝐃 𝐄𝐄+𝐃𝐃

It turns out that, if the firm adjusts its leverage to maintain a target debt-to-value
ratio, then its pre-tax WACC is equal to the unlevered cost of capital rU.

With rU independent of D/V, rWACC decreases in leverage as long as τ > 0.

VU = PV(FCF, rU) ; VL = PV(FCF, rWACC) ; rWACC < rU ; and VL – VU = PV(ITS)

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MM 2 With Taxes & WACC

rE
Cost of Capital

rU Pretax WACC

WACC with taxes

rD
rD(1 - τ)

D/(D+E)
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Limits to Tax Benefits & Preference for Debt
• If EBIT>0, the unlevered firm pays τ × EBIT in corporate taxes.

• The firm can borrow an amount D and reduces its taxes to τ × (EBIT – rD×D).

• Borrowing D = EBIT / rD makes EBIT – rD×D = 0 and maximizes interest tax shields.

• Borrowing more than D = EBIT / rD does not make sense:

• no extra interest tax shields
• the firm could become financially distressed (EBIT < rD×D ), which is costly

• This implies that more profitable firms (higher EBIT) should borrow more!

• Note: CCA / Depreciation, investment tax credits, and carryforwards of past losses
reduce taxable income → firms with large non-debt tax shields will borrow less!
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Summary so far:
• Corporate taxes are one of the most important imperfections in capital markets.

• Dividend payments are not tax deductible, but interest payments are. This can be
seen as a government subsidy to borrowing that encourages debt issuance.

• MM1: issuing debt now creates value as the firm saves corporate taxes
• a general results that applies for any capital structure policy
• with fixed debt levels, interest tax shields can be discounted at the cost of debt
and are easy to calculate → a simpler expression of MM1 that is handy

• MM2: issuing debt increases equity risk and cost of equity

• same intuition as without taxes, but slight change to algebraic expression
• tax shields make equity safer → debt increases cost of equity by less than before

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Recapitalizing to Capture the Tax Shield
RCS Corp has 100M shares worth $7.2 each and no debt. Its cost of capital is 5%.
Its expected annual cash flow before taxes is $60M forever. It pays taxes at 40%.
RCS will issue $500M in perpetual debt at 2% interest and buy back shares.

Before the recap:

rU = 5%
VU = $60M×(1 – .4) / .05 = $720M (or 100M×$7.2)
E(EPS) = $60M×(1 – .4) / 100M = $0.36

After the recap:

VL = $720M + .40×$500M = $920M [MM1]
EL = $920M – 500M = $420M [# shares and price still unknown]
rE = .05 + (500/420)×(.05 – .02)(1 – .4) = 7.143% [MM2]
rWACC = (500/920)×.02×(1 –.4) + (420/920)×.07143 = 3.913%
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Recapitalizing to Capture the Tax Shield (cont.)
Announcement (firm is still unlevered)
• equity’s value goes up to $920M → share price goes up to $9.2 ($920M / 100M)
• each share gains $2 in PV(ITS) ($200M / 100M) → a 27.8% return on announcement

Transaction
• RCS raises $500M in debt and repurchases $500M / $9.2 = 54.35M shares

After Recap:
• shares outstanding = 100M – 54.35M = 45.65M
• E(EPS) = ($60M – .02×$500M)×(1 – .4) / 45.65M = $0.66
• share price = $0.66 / 7.143% = $9.2
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RCS’s Recapitalization Step-by-Step – The Market-Value Balance Sheet
Market Values ($ M) Initial Announced Debt Share
Issuance Repurchase
Assets
Cash 0 0 500 0
VU 720 720 720 720
PV(ITS) 0 200 200 200
Total 720 920 1,420 920

Liabilities & Equity

Debt 0 0 500 500
Equity 720 920 920 420
Total 720 920 1,420 920

Shares outstanding (M) 100 100 100 45.7

Share price ($) 7.2 9.2 9.2 9.2
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RCS’s Recapitalization Step-by-Step - Discussion
• Before the unexpected recapitalization is announced, RCS is unlevered.

• Upon announcement, RCS is still unlevered (no change in capital structure yet), but
investors recognize that the recapitalization will soon create value for them (MM1):
• RCS’s unlevered value goes up to its post-recapitalization (levered) value
• why? Investors understand the firm will save taxes and is thus worth more!
• the # of shares is still unchanged → the price increases by the PV(ITS) per share

• On transaction date, things happen as expected, so no further impact on firm value

or stock price, but now the anticipated capital structure change occurs:
• cash raised with debt is used to repurchase shares (in and out of the firm)
• with some shares withdrawn, now the number of shares outstanding decreases
• firm value is unchanged, but equity value drops to make room for debt value
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Recapitalizing: Dividends vs. Repurchases
RCS will issue $500M in perpetual debt at 2% interest, as before, but now it will pay out
the proceeds using a special dividend of $5 per share (rather than repurchasing).

Before: VU = $720M ; p = $7.2 ; rU = 5% ; E(EPS) = $0.36

Announcement: VU = $920M ; p = $9.2 (“cum-dividend”)

After: VL = $920M ; p = $4.2 ; EL= $420M ; rE = 7.143% ; rWACC = 3.913%

E(EPS) = ($60M – .02×$500M)×(1 – .4) / 100M = $0.30 (<$0.66 w/ repurchase)

Note EPS is lower with dividend, but this should not matter to shareholders.

Transaction: the share price falls by the $5 dividend per share to $4.2 (“ex-dividend”)

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 Anecdote: Nathan’s Famous (2015)
In March 2015, the unlevered and New York-based hot dog seller Nathan's Famous
(NATH) levered up and used the proceeds to pay a huge special dividend to investors.
Sold $135 million in junk bonds with a 10% coupon rate and paid a $25 special
dividend per share, 34.9% of its stock price, levering up to D/V = 30% in one day.
A very criticized transaction. Story from Forbes [web] ; Price effects & criticism [web]
At announcement (March 10th) price increased marginally to $72.
Little change in the price between announcement and transaction.
On transaction (really ex-dividend) day (March 30th), price drops by about $25.
Price drops steadily until end of August – market now reacts negatively.
In the longer run, Nathan’s Famous did great (price back to $75 by December 2018).

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The Zero Leverage Puzzle
• The tax benefits associated with debt imply that profitable firms should borrow, but
about 10% of US firms keep zero leverage and about 22% have very low leverage.

• This often happens for small and growing firms, but also happens for long periods of
time even for larger firms with good access to credit (e.g., Lululemon) – a puzzle!

• Lulu: VU = $38.6B & τ = 27%

• with $10B in perpetual debt PV(ITS)=.27×10B=$2.7B (7% gain)
• leverage would be about D/V = 21%

• Why are these firms leaving money on the table (failing to optimize tax shields)?
• are there big costs associated with even little leverage we need to worry about?
• a need to keep large “unused debt capacity” (e.g., for acquisitions)?
• weak governance and undiversified CEOs’ preference for low leverage?
• undiversified ownership structure, e.g., in family firms?
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Recent Legislation Capping Deductibility of Interest
• Many economists believe that debt (interest) and equity (dividends) should be taxed
the same way, to avoid a distortion of capital structure choices in favor of debt.

• Some also argue that highly levered firms go bankrupt and need to be bailed out, so
constraining their borrowing appetite might be beneficial.

• The Republican tax reform signed into law in December 2017 in the US introduced a
cap to the corporate interest deduction at 30% of EBITDA - a step in that direction.

• Affected corporations were likely those for which the cap was binding, but it remains
to be studied exactly how this ultimately affected leverage decisions.

• While capping the interest deductibility was “bad for business”, it came together with
a sweeping tax reform that reduced the corporate tax from 35% to 21%.

• See a discussion of similar legislation for Canada coming into effect in Jan 2023 [web]
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Summary
• As the transaction is unexpected and will happen for sure, all price effects occur at
the announcement when investors realize the value effects of the transaction.

• Shareholders capture the benefits – interest tax shields – at the announcement.

• The share buyback occurs at a price that already adjusted to reflect the gains.

• Firm value goes up (MM1), cost of equity goes up (MM2), and WACC decreases.

• Debt proceeds can be paid out in a share repurchase or with a special dividend.

• The choice of payout affects EPS, but not the value created by the transaction.

• Some firms maintain zero-leverage; recent regulation caps interest deductibility.

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Class activity: Delevering a Company
Rhino Corp has 50M shares worth $10 each, $750M in perpetual debt with 5%
interest per year, a 30% tax rate, and a cost of equity of 15% per year. The firm plans
to issue equity and retire all of its debt, and to remain unlevered afterwards.

a) What is Rhino’s firm value, debt ratio, and WACC before the announcement?

b) What is Rhino’s firm value, equity value, and cost of capital with an all-equity
capital structure? What is the intuition behind the changes vs. the levered firm?

c) What is Rhino’s firm value, equity value, and share price at the announcement?
What is the intuition behind the announcement effects?

d) How many shares will Rhino issue to retire its debt? What is the new # of shares?

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Class activity: Delevering a Company – Solution
Rhino Corp has 50M shares worth $10 each, $750M in perpetual debt with 5%
interest per year, a 30% tax rate, and a cost of equity of 15% per year. The firm plans
to issue equity and retire all of its debt, and to remain unlevered afterwards.

What is Rhino’s firm value, debt ratio, and WACC before the announcement?
EL = 50M×$10 = $500M
D = $750M
VL = $500M + $750M = $1,250M
D/E = 1.5 and D/V = 60%
rWACC = .4×15% + .6×5%×(1 – .3) = 8.1%

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Class activity: Delevering a Company - Solution (cont.)
What is Rhino’s firm value, equity value, and cost of capital with its new all-equity
capital structure? What is the intuition behind the changes vs. the levered firm?

VL = VU + t×D (MM1)
$1,250M = VU + .3×$750M → VU = EU = $1,025M
Firm value drops by the PV(ITS) lost, from $1,250M to $1,025M

rE = rU + (D/E)×(rU – rD)×(1 – t) (MM2)

15% = rU + 1.5× (rU – 5%)×(1 – .3) → rU = 9.9%
The cost of equity drops from 15% to 9.9% because financial risk was eliminated.
The overall cost of capital increases because the effective borrowing cost increased.

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Class activity: Delevering a Company – Solution (cont.)
What is Rhino’s firm value, equity value, and share price at the announcement?
What is the intuition behind the announcement effects?
The firm is still levered, but investors understand the PV(ITS) will be lost.
Firm value drops to VL = $1,025M → EL = $1,025M – $ 750M = $275M
But the number of shares has not changed yet!
Share price drops to $275M / 50M = $5.5 (a $4.5 drop = PV(ITS) lost per share)

How many shares will Rhino issue to retire its debt? What is the new # of shares?
Shares issued = amount to raise / share price = $750M / $5.5 = $136.4M
Total new shares = 50M (old) + 136.4M (new) = 186.4M

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