Subject Financial Management Paper No. and Title Module No. and Title Module Tag Paper No.8: Financial Management Module No. 25: Capital Structure Theories IV: MM Hypothesis with Taxes and Merton Miller Argument COM_P8_M25
TABLE OF CONTENTS 1. Learning outcomes 2. Introduction 3. How proposition 1 of MM s hypothesis works in the presence of corporate taxes? 4. Proposition 2 with corporate taxes: Capital structure affects shareholders returns 5. Criticism of MM s hypothesis with corporate taxes 6. Summary
1. Learning Outcomes After studying this module, we shall be able to: Highlight the difference between Modigliani-Miller approach of without taxes and Modigliani-Miller approach including corporate taxes Focus on the interest tax shield advantage of debt as well as its disadvantage in terms of costs of financial distress Show how the value of a firm increases with increase in leverage in the presence of corporate taxes Analyze the various criticisms of MM approach with including corporate taxes 2. Introduction MM hypothesis of irrelevance of capital structure mainly holds true because it assumes that the corporate taxes are absent. Thus, the levered and unlevered firms stand on the same footing. But, in reality this is not the case. Firms do have to pay corporate taxes and as we know that the interest paid on debentures is tax deductible. Hence, it becomes more profitable for a firm to have leverage (debt) as it saves taxes and thus the value of such a firm increases. Thus, in the presence of corporate taxes, MM hypothesize that the value of a firm increases as the leverage increases. 3. How proposition 1 of MM s hypothesis works in the presence of corporate taxes? Presence of corporate taxes Tax advantage of interest payment to levered firm Net operating income of levered firm > Net operating income of unlevered firm after tax Value of levered firm > Value of unlevered firm 1.) Net Operating Income After Tax (Tax Advantage) Suppose there are two firms Firm U and Firm L. Firm U is an unlevered firm with all equity capital. Firm L is a levered firm which has Rs 50,000 debt at 10% interest in its total capital. Net operating income of both the firms is Rs 2,500. Firms are required to pay 50% as corporate taxes and dividend payout is 100%.
We know that, interest payment on debt is tax deductible; the levered firm will get a tax advantage as compared to unlevered firm. This amount of tax advantage is called Interest Tax Shield (INTS) or Tax advantage of Debt. This advantage will increase the net operating income after tax of the levered firm as compared to unlevered firm. Let s calculate the net operating income after tax of the two firms:- Firm U Firm L Net operating income before tax 2500 2500 Less: Interest (10% of Rs 5,000)... 500 Taxable Income 2500 2000 Less: Tax @ 50% 1250 1000 Income to shareholders after tax 1250 1000 Add: Interest 500 Net operating income after tax 1250 1500 Therefore, Interest tax shield (Tax advantage of debt) = Rs 1500 - Rs 1250 = Rs 250 Relative advantage of debt = 1500/1250 = 1.20 Thus, it is very clear from the above table that net operating income after tax of levered firm is more than unlevered firm by Rs 250. It is also clear that tax payment of levered firm is less than unlevered firm by the same amount i.e. Rs 250, which is interest tax shield. Therefore, Interest Tax Shield = Savings in Tax = Tax on Interest INTS = T Interest INTS = T K d D 2.) Value of Firm As we just discussed that the tax advantage (INTS) increases net operating income after tax of the levered firm as compared to unlevered firm. Now, as the net operating incomes of two firms are different, their value will also be different. Let s first calculate the value of unlevered firm. Suppose the cost of equity is 12.5%, which is same as average cost of capital for unlevered firm. We know that, Value of a Firm = Net operating income after tax Cost of capital V U = Net operating income after tax = Rs 1250
Cost of equity (K e) 0.125 So, Value of unlevered firm = Rs 10,000 Now let s consider the value of levered firm. As we already know that the levered firm has higher operating income than unlevered firm, its value will also be higher. The operating income of levered firm is equal to operating income of unlevered firm plus interest tax shield INTS (i.e. 1500 = 1250 + 250). Hence, the value of levered firm will be the value of unlevered firm plus the value of INTS. So, Value of levered firm = Value of unlevered firm + Value of INTS V L = V U + P.V. of INTS Value of INTS:- As the interest tax shield is an extra income of firm, it has some value. Suppose that the current level of debt of Rs 5,000 will remain permanent and as the tax rate remains same for a long period of time, the INTS will keep on generating over a long period of time on continuous basis. Thus, it forms perpetuity. The value of INTS will be same as value of perpetuity. Value of Perpetuity = Installment per period ROI (Discount rate) Thus, we need a rate of discount to show riskiness of this INTS. INTS depends on rate of interest on debentures and corporate tax rate. Corporate tax rate remains same and the interest rate depends on rate of earning which is at least equal to rate of borrowing. The INTS is less risky than earnings, thus the discount rate can be taken as at least same as rate of interest on debt (i.e. 10%). Thus, the value of INTS will be:- Present value of INTS = INTS = Rs 250 = Rs 2,500 K d 0.10 P.V. of INTS = T K d D = T D K d Thus, the value of INTS does not depend on rate of interest on debt but on amount of debt and tax rate (i.e. 0.5 5000 = Rs 2,500). As we know that tax rate remains constant over a period of time, so, if the amount of debt increases the value of INTS also increases and becomes maximum at 100% debt level. So, V L = V U + T D Thus, Value of levered firm = Rs 10,000 + Rs 2,500
= Rs 12,500 Hence, it is very clear that the value of levered firm is greater than unlevered firm by the value of INTS. Thus, it can be concluded that the value of levered firm will keep on increasing as the debt portion increases and it will be maximum when debt is 100%. It is shown in the following figure: 4. Proposition 2 with Corporate Taxes: Capital Structure affects shareholders returns As discussed earlier that in case of no corporate taxes, the returns to equity holders increases as the leverage increases. The same result holds true in case of existence of corporate taxes as well. With increase in leverage, the risk of shareholders earnings increases and for this they expect a higher rate of return. However, the amount by which return of shareholders increases on increase in leverage is different when we have corporate taxes. In case of no taxes, the return of shareholders is given as:- K e = K a + (K a K d) D
E However, with the existence of corporate taxes, the return of equity holders gets reduced by the amount of tax savings. As the firms get interest tax shield, the risk of the shareholders gets reduced by this amount and their expected return is also reduced in the same proportion. Thus, their return is given as:- K e = K a + (K a K d) (1 T) D E Hence, it can be concluded that in case of corporate taxes also, shareholders returns increase on increase in leverage, but this increase is lesser as compared to the case when there are no corporate taxes. 5. Criticism of MM s Hypothesis with Corporate Taxes It is proposed by MM in the presence of corporate taxes that the value of firm increases with increase in leverage. Thus, it can be said that a firm can increase its value by increasing its leverage and maximize it by employing 100% debt in capital. But, this proposition is criticized for its practical application. That is in practice, firms do not employ very high levels of debt and lenders also do not lend the money beyond a limit. Therefore, the debt portion never becomes 100% but firms choose an optimum level of debt. The reasons for this are:- 1. As the debt increases, the savings of corporate taxes also increases and at the same time the amount of personal taxes to be paid also increases. Thus, the liability of personal taxes offsets the advantage of corporate taxes. 2. Greater amount of debt also increases financial risk of the firm. Thus, the cost of financial distress also increases which again offsets the advantage of corporate tax savings. 6. Summary One unrealistic assumption of MM s hypothesis is that, they assume no existence of corporate taxes. When there exists corporate taxes, firms can increase earnings of all investors through borrowing which results in interest tax shield. The value of perpetual interest tax shield (PVINTS) is equal to T D. The market value of levered firm will be equal to the market value of unlevered firm plus the present value of interest tax shield (TD). V L = V U + T D The above equation implies that a firm can continuously increase its value by borrowing more debt. Thus, firms should have 100% debt in their capital structures.
In practice, we do not find many firms employing high amount of debt. The reason for this could be personal taxes and financial distress. In case of corporate taxes, shareholders return also increases with increase in leverage but this increase is lesser as compared to the case when there are no corporate taxes.