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.