I’m having mental block at the moment. I understand mathematically how employing debt in your capital structure increases value (smaller denominator), but can someone explain how the tax deductable aspect plays into increasing value and justifying the use of debt. Why I’m stumping myself:
w/Debt Equity
EBIT 100 100
Int Exp 5 0
EBT 95 100
Taxes @ 40% -38 -40
Net Income 57 60
Based on the above, Yes…debt reduces total taxes paid by $2 but you still have less overall distributable cash (net income) by using debt as opposed to a debt-free cap structure. If you discounted those cash flows, the all equity scenario would generate the higher value…so what am I overlooking???
Keep in mind that equity does not come free, unless it’s generated internally.
In most cases, the required return on equity is greater than the cost of debt (you are issuing stocks to bring in unwanted owership in the company). So it would make sense for companies to use some debt in their capital structure. According to the trade-off theory, the marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases due to increasing financial risks (higher interests burden) so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.
But does that really answer why the tax deductuble nature of debt increases value. In my example you still wind up with less income than with all equity and no interest payments…so why use debt then? I don’t care so much that I saved $2 in taxes if I have still have $3 fewer dollars overall, right?
It is beneficial for companies to use some debt in their captial structure.
(unless funded by 100% internally generated equity)
Tax savings reduce the cost of debt. (hence increases company value)
I guess the assumption for the tax savings to increase company value is that your company will need to use some sort of debt in the captial stucture. It doesnt increase value when your company does not need to use any debt at all because 100% of equity is internally generated (in your example).
You’re really going to make me draw this out, aren’t ya… That’s ok.
100% Equity firm:
$1,000,000 in equity
$0 in debt
Earnings of $100,000 per year.
100,000/1,000,000 = 10% ROE.
50% Equity firm:
$500,000 in equity
$500,000 in debt at 5% interest rate, 20% tax rate
EBIT of $100,000 per year less 25,000 in interest expense plus 5,000 in tax reduction = NI of $80,000
80,000 / 500,000 = 16% ROE
Lower net income, but you earn more per dollar of equity. You’ve now freed up $500,000 of equity to invest elsewhere. That’s a higher return. Stop looking at net income and thinking higher net income is better. It’s about RETURN
–.
And stop this internally generated equity nonsense. That has a cost too. It could be distributed to your shareholders. It’s not free!
You are looking at only 1 side of the equation. In your example, Suppose the company with debt is financed with $200 equity and $200 debt vs, the 2nd column with $400 equity. For comparison purposes, suppose the $200 equity is represented by 20 shares vs. $400 equity represented by 40 shares.
Which would have higher EPS? Which share would be worth more?
sounds to me like you’re comparing 'the value you’re adding to the company’ to 'the return you’re generating for existing shareholders’.
say in the case of more equity in the structure, sure, the company on the whole is better off by not incurring debt-related expenses, but that value is then spread over a bigger pie /equity, so per slice of equity, there’s less return being generated.
in the case of more debt, on the other hand, the company on the whole is worse off because of additional debt-related expenses, but the slightly reduced return is shared by a much smaller size equity, so per share of equity, there’s more return for each existing shareholder.
tax is rather irrelevant in this comparison. re: your original post, tax is not used to increase value or justify the use of debt. tax just makes using debt less expensive.
re: geo’s excellent explanation above, what matters is the return per dollar of your investment. not the value of the company, but the value of the company to each shareholder.
Which second side of the equation you have in mind?
In you rexample, both the EPS and the share price of leveraged company will be higher that that of the equity-only company. I assume full pay-out for both Options.
Option A Option B Debt @5% 200 Equity 200 400 Option A Option B EBIT 100 100 Interest 10 - EBT 90 100 Taxes@40% 36 40 Net Income 54 60 /#shares 20 40 EPS 2.7 1.5 Div/share 2.7 1.5 /Cost of Equity 11.61% 8.31% Share Price 23.26 18.05
Cost of equity is calculated using CAPM and the following assumptions:
A tax deduction no matter from which source diminishes the cash flow to the authorities and therefore increases cash flows to other stakeholders, e.g. bondholders and shareholders.
It does not necessarily increase value. It does increase value if the cost of capital does not change.
If the tax dedcution is a result of introducing the debt, then after a certain point the cost of capital (WACC) can increase and the value will decrease.This point occurs when the amount of debt in company’s capital structure is too high, which causes cost of debt to be too high.
Why though is the assumption that you have fewer shares outstanding if you have debt? Gio, what if you had 40 shares under both capital structures…then the equity side is better, no?
Your last post indicates where the confusion is. Debt and equity are two sources of interchangeable capital. If you have more debt, you NEED less in equity. Hence number of shares is lower in the case of debt.
That makes sense CMLSML, but say my company is 100% equity with 100 shares currently outstanding. Taking out debt in the future doesn’t reduce the number of shares outstanding, right? So If i have the same shares outstanding with less income (less interest exp), won’t my EPS go down and value to go with it?
What are you doing with the money from your issued debt? You’re buying back shares or investing in income producing assets. If those assets produce more income than interest expense (and if they don’t… you wouldn’t do the deal), then your EPS has gone up.