Debt and Taxes





Kerry Back

How much debt should a company have?

  • Companies have a wide range of debt levels.
    • Public companies usually relatively low.
    • Private equity/leveraged buyout funds relatively high.
  • What are the pluses and minuses?

Hold investments and operations constant

Consider a financial structuring with no effect on investments or operations. For example,

  • Company is going to invest and can issue shares or borrow money.
  • Company could issue shares to pay down debt.
  • Company could borrow money to repurchase shares.

Goal is to increase enterprise value

Anything that increases enterprise value is good for shareholders. Example:


  • Suppose EV = 300, debt=100, equity=200
  • Suppose we can borrow 20 more to repurchase shares and increase EV to 310.
    • Now debt = 120
    • Equity = 190
    • Shareholders get 20 in share repurchases, so 210 total.

Government’s share

  • There are three claims on a company: shareholders, lenders, and the IRS.
  • Value of company = enterprise value (debt + equity) + IRS claim.
  • Reducing IRS claim will increase enterprise value and therefore benefit shareholders.
  • Reducing IRS share is a positive NPV activity just like a good investment project.

Example

  • All equity company with 100 in pre-tax income in perpetuity. Tax rate is 30%. Invested capital constant forever.
  • Suppose equity value is 500.
  • Company issues 200 in perpetual debt @ 5% and repurchases shares.
    • Taxes are reduced by 200 times 5% times 30% = 3
    • PV of tax savings is 3/0.05 = 60.
    • Enterprise value \(\rightarrow\) 560. Shareholders benefit.

Trade-off theory


Companies should borrow to get tax savings up to the point that the marginal cost of potential financial distress equals the marginal benefit of tax savings.