Capital Structure Theories^275
Table: Income of Investors of Unlevered and Levered Firms: Income
Income Firm U Firm L- EBIT,
X
2,500 2,500- Interest, INT = kd I) 0 700
- Profit before tax,
X
- kdD 2,500 1,800
- Tax,T(
X
-kdD) 1,250 900- Profit after tax (
X
- kdD)- T (
X
- kd D) = (
X
- kd D) (1 - T) 1,250 900
- Dividends to shareholders, (
X
- kdD) (I - T) 1,250 900
- Personal taxes on dividends, Tp [(
X
- kd D) (I - T)] 500 360
- Dividends after personal taxes, (
X
- kd D) (I - T) (I - Tp) 750 540
- Interest to debt-holders, kd D 0 700
- Personal taxes on interest, Tp (kd D) 0 280
- Interest after personal taxes, (kd D - Tp kd D) = kd D (I - Tp) 0 420
- Total income to investors, (8 + 11) (
X
- kd D) (I - T)
(I - Tp) + kd D (1 - Tp) 750 960
- Interest tax shield after personal taxes,
kd DT - kd DT ◊ Tp (I = Tp) kd DT - 210
Note that the after-tax income available to both shareholders and debt holders is less
by 40 per cent on account of personal taxes. Further, you also notice that the interest
tax shield after personal tax has reduced to: Rs 350 (1 - 0.4) = Rs 210. What is the
present value of this perpetual stream? We shall have to adjust the discount rate for
the personal taxes. This is done because the cash flows arising from the interest tax
shield are computed after personal taxes. The debt holders of firm L can obtain 14 per
cent before tax, but only 0.14 (1 - 0.4) = 0.08 or 8.4 per cent after personal tax. Thus,
the present value of interest tax shield is:PVINTS =
=Rs 2,500This present value is same as obtained earlier when the personal taxes were ignored.
It is because both cash flows and discount rate have been reduced by the personal tax
rate of 40 per cent. ThusPVINTS =Corporate tax rate Interest Personal tax rate
Cost of debt Personal tax rate¥ ¥ -( )
( )1
1
=¥ ¥ -
=...(16)
The value of the levered firm is still given by the following formula:
Vt = Vu + TD
In reality, however, dividends are treated differently from interest income for tax