Debt vs equity

Interest is taxed at the receiving end and dividends at the payers end at the same rate.

How can debt be cheaper than equity due to tax? SUrely that tax liabilityis just shifted from one person to another?

 

Let me assume the following:

1. You have the potential to run a business and make an operating profit (earnings before interest and taxes) of $10m.
2. You would need a $25m capital and you don't have it.
3. And The only one to fund you is me (since i'm making the assumption).
4. I require a 10% pretax return on my investment.
5. Our business pays tax @ 50%


Let's examine a 100% equity investment from my side:

EBIT : 10.0
Profit before tax : 10.0
Less:Tax : 5.0
Profit after tax : 5.0
Less: Dividends : 2.5
Retained Earnings : 2.5


Let's now examine a 100% debt investment from my side:

EBIT : 10.0
Less: Interest : 2.5
Profit before tax : 7.5
Tax : 3.7
Profit : 3.8
Retained Earnings : 3.8


Here the net cost of debt is actually 1.25m (2.5-(2.5*50%)). That is the company has suffered only 1.25m as cost and the balance 1.25 has actually gone to save income taxes. Now the net cost of debt to the company as percent of capital invested is only 5% (1.25m/25m). Whereas in the 100% equity case, the cost of capital was 10% (5m/25m).

And if you were to contribute just $1 as equity in any of the above two scenarios, you would certainly choose only debt which will give you a return close to infinity ($3.8m/$1) as against almost nothing (since you have invested only $1 and i have invested $25m)

Guess that clarifies...

Arun

 

I hope I didn't misunderstand your question...

 

No...

My assumption is that tax rate is 50% coporation and personal, say.

I demand 10% return post tax.

Equity basis:
retained earnings for the company on equity basis would then be the same as you stated.

Debt basis:
i would require a 20% return pre tax as my tax rate is 50% so change your borring cost to 5.

retained earnigns are the same.

I suspecet that this issue is tax avoidance. While debt is tax deductible in the country the coporation is in (from the company's perspective), the debt owners income is probably recycled through a tax haven/ never declared.

 

Interesting question, where did you get it?

If I were to hazard a guess (since I don't really know),
it could have to do something with timing (payment on receiving is later than paying? - same nominal but lower time value)
might have something to do with dividends have already been taxed and can't be reclaimed (did tax credits stop for certain cases?) so you may be taxed at worse(higher) of average case and your individual case, whereas the income will be taxed at your indivudual circumstances.
Might affect double taxation treatments

 

In general, a company isn't in a position to do anything about the tax liabilities of its owners, so all it can do is maximise its own profit (by increasing debt capital).

In practice, I can't really imagine a situation where you'd have a free choice of investing as debt or equity...

 

After wandering off to make a cup of tea, the thought also struck me that in the UK at least, corporate tax is held to cover a shareholders basic rate payments due on their dividends.

 

I didn't get it anywhere. When I was studying this subject I thought the whole debt is cheaper because of tax bit a bit fishy.

I know in the real world tax rates differ etc. I just think if it is in general true, it is because of those Belgian dentists and their eurobonds.

 

My point exactly. If both rates were the same and you were you to have no personal allowance.... you are just shifit g teh payment of the same tax on the same cashflow from one party to another.

 

Most large companies have both debt and equity which is freely traded.

 

It's easy enough to buy debt or equity on the secondary market, but if you walked up to, say, Boots and offered to invest £5m I'm pretty sure they'd have a preference for debt or equity and would offer terms commensurate with that.

But that's not the company's problem - it has no way of knowing its investor's tax status. It could be a charity with no tax liability at all, or an overseas investor with quite a different tax liability. So all the company can do is lever up and maximise its own profits.

 

I think we should look at only the company's standpoint when you want to evaluate whether debt is cheap or equity is cheap. From the company's standpoint Debt is usually (not at all times) cheap because it of its tax deductibilty. On the downside, if you leverage your business too much just because debt is cheap, then you might find it difficult is tougher times of business. Interest payments are mandatory while dividends are optional. Debt owners are usually more secured than a equity holders. Even in times of bankruptcy the debt owners have to be discharged first. And it actually makes sense this way. More security, less risk and less return in debt. There is a higher risk in equity and hence the higher return.