Introduction to Corporate Finance

13: Capital Structure

The introduction of a 35% corporate profits tax causes an immediate $3,500,000 reduction

(from $10,000,000 to $6,500,000) in the market value of the current all-equity structure of HTMC.

13 -3b DETERMINING THE PRESENT VALUE OF INTEREST

TAX SHIELDS

Equation 13.3 reveals that corporate taxes cause a reduction in the value of an unlevered company,

compared with its value in a zero-tax environment. Now let’s consider how HTMC can increase company

value by using debt financing to fund some of its investment. Remember, this increase in value occurs

directly because the company can deduct interest on debt and reduce what it owes the government in taxes.

If the new debt which HTMC will issue under the proposed 50% debt/50% equity plan is assumed

to be permanent – meaning the company will always reissue maturing debt – the interest expense the

company pays creates a perpetual tax shield of $105,000 per year. The annual tax shield equals the tax

rate times the amount of interest paid (Tc × rd × D = 0.35 × 0.06 × $5,000,000 = $105,000). To find the

present value of this perpetuity, capitalise this stream of benefits at rd, the 6% rate of interest charged on

HTMC’s debt. With these assumptions, the present value of HTMC’s interest tax shields is:

Eq. 13.4 PV TrD

r

(Interesttaxshields)= TD

()

0.35 ($5, 000, 000 )$1, 750, 000

cd

d

c

×

=×

=× =

In other words, the present value of interest tax shields on (perpetual) debt is equal to the tax rate

times the face value of the debt outstanding. Therefore, the value of the levered version of HTMC, Vl, is

equal to the value of the unlevered company plus the present value of the interest tax shields:

Eq. 13.5 Vl = Vu + PV (Interest tax shields) = Vu + TcD

= $6,500,000 + $1,750,000 = $8,250,000

What a deal! In essence, the government has given HTMC’s shareholders a $1,750,000 subsidy to

employ debt financing rather than equity.

Figure 13.4 illustrates the impact of taxes on company value. Panel A represents the situation in the

original, no-tax case: there, the size of the pie – the value of the company – does not depend on how you

divide the pie between debt and equity claims. With a corporate income tax, though, a company’s capital

structure influences its value: debt determines how much of the pie goes to the government. The more

the company borrows, the smaller is the government’s claim, and thus the larger are the claims held by

private investors. Panel B of Figure 13.4 illustrates this point. At the limit, the government’s slice (its

tax claim) disappears when the company finances its operations entirely through debt and pays all its

earnings in tax-deductible interest.

example

In December 2014, Facebook used essentially no

long-term debt, and its equity had a market value

of $US226.1 billion. In the absence of debt, this

implies that Facebook’s assets were also worth

$US226.1 billion. What would happen to the

total value of Facebook if the company issued

$US113 billion in long-term debt and used the

proceeds to retire half of its equity? According to

Equation 13.4, if Facebook faces a US corporate tax

rate of 35% then the recapitalisation would create an

additional $US39.6 billion (0.35 × $US113 billion) in

value for Facebook investors!

Data from https://ycharts.com/companies/FB/market_cap.

Accessed 4 January 2016.

LO 13.2

If we issue $10 billion in

long-term debt and use the

proceeds to repurchase shares,

what effect (qualitative and

quantitative) will this have on

our share price?

thinking cap

question