74 Part 2 Fundamental Concepts in Financial Management
Of course, it is generally not possible to! nance exclusively with debt; and the
risk of doing so would offset the bene! ts of the higher expected income. Still, the
fact that interest is a deductible expense has a profound effect on the way businesses are
" nanced—the corporate tax system favors debt " nancing over equity " nancing. This point
is discussed in more detail in the chapters on cost of capital and capital structure.^18
Corporate Capital Gains
Before 1987, corporate long-term capital gains were taxed at lower rates than cor-
porate ordinary income; so the situation was similar for corporations and individ-
uals. Currently, though, corporations’ capital gains are taxed at the same rates as
their operating income.
Corporate Loss Carry-Back and Carry-Forward
Ordinary corporate operating losses can be carried back (carry-back) to each of the
preceding 2 years and carried forward (carry-forward) for the next 20 years and
used to offset taxable income in those years. For example, an operating loss in 2008
could be carried back and used to reduce taxable income in 2006 and 2007; it also
could be carried forward, if necessary, and used in 2009, 2010, up until 2028. The loss
is applied to the earliest year! rst, then to the next earliest year, and so forth, until
losses have been used up or the 20-year carry-forward limit has been reached.
To illustrate, suppose Company X had $2 million of pretax pro! ts (taxable income)
in 2006 and 2007 and then in 2008, it lost $12 million. Its federal-plus-state tax rate is
40%. As shown in Table 3-8, Company X would use the carry-back feature to recom-
pute its taxes for 2006, using $2 million of the 2008 operating losses to reduce the 2006
pretax pro! t to zero. This would permit it to recover the taxes paid in 2006. Therefore,
in 2008, it would receive a refund of its 2006 taxes because of the loss experienced in- Because $10 million of the unrecovered losses would still be available, X would
repeat this procedure for 2007. Thus, in 2008, the company would pay zero taxes for
2008 and would receive a refund for taxes paid in 2006 and 2007. It would still have
$8 million of unrecovered losses to carry forward, subject to the 20-year limit. This $8
million could be used until the entire $12 million loss had been used to offset taxable
income. The purpose of permitting this loss treatment is to avoid penalizing corpora-
tions whose incomes " uctuate substantially from year to year.
Consolidated Corporate Tax Returns
If a corporation owns 80% or more of another corporation’s stock, it can aggregate
income and! le one consolidated tax return. This allows the losses of one company
Tax Loss Carry-Back or
Carry-Forward
Ordinary corporate
operating losses can be
carried backward for 2
years and carried forward
for 20 years to offset
taxable income in a given
year.Tax Loss Carry-Back or
Carry-Forward
Ordinary corporate
operating losses can be
carried backward for 2
years and carried forward
for 20 years to offset
taxable income in a given
year.(^18) A company could, in theory, refrain from paying dividends to help prevent its stockholders from having to pay
taxes on dividends received. The IRS has a rule against the improper accumulation of retained earnings that would
permit this. However, in our experience, it is easy for! rms to justify retaining earnings; and we have never seen a
! rm have a problem with the improper accumulation rule.
Use Bonds
(1)
Use Stock
(2)
Sales $5,000,000 $5,000,000
Operating costs 3,500,000 3,500,000
Earnings before interest and taxes (EBIT) $1,500,000 $1,500,000
Interest 1,500,000 0
Taxable income $ 0 $1,500,000
Federal-plus-state taxes (40%) 0 600,000
After-tax income $ 0 $ 900,000
Income to investors $1,500,000 $ 900,000
Rate of return on $10 million of assets 15.0% 9.0%
Tabl e 3 - 7 Returns to Investors under Bond and Stock Financing