Tax Shields, Debt & Equity Financing
This article will explore how firms finance their investments, the advantages of debt financing over equity financing, with a focus on the tax shields and how companies exploit this, before finishing with a brief analysis on the impact of Coronavirus on corporate debt.
How Do Companies Finance Their Investments?
Debt financing and equity financing are the two main approaches used by firms to raise funds. Companies can either take on debt by issuing bonds (a fixed-income instrument that represents a loan made by an investor to a borrower) in order to raise capital, which is paid back with interest payments. Or they can sell shares in the company with the promise of paying dividends (a distribution of a portion of the company’s earnings) to its shareholders. The issuance of fresh stocks or bonds by a company is called an initial public offering (IPO). The country’s tax system creates distortions impacting which method of financing is preferred. An additional aspect to note is that firms may also choose to issue debt to take advantage of the low borrowing costs (low-interest rates).
Let’s start by understanding how companies are taxed. With the exception of a few countries, most impose an income tax on both individuals (personal income tax) as well as businesses (corporate income tax). Companies will first incur an income tax on corporate income. Then, when firms pay their shareholders in the form of dividends, the shareholders will be taxed again as this is now classified as personal income. This results in the issue of double taxation. Dividends are effectively being taxed twice. This is a major disadvantage of equity financing, which can affect how a firm allocates its equity and debt. Some companies may look to reinvest earnings instead of paying out dividends just to avoid the personal income tax on dividends.
Debt Tax Shield
On the other hand, this problem of double taxation is not applicable to debt financing. The lenders of the capital are not owners of the company. Therefore, interest payments can be considered as a cost for the firm, making it a tax-deductible expense. As a result, these payments will not incur corporate income tax, and lenders will only have to pay personal income tax (interest payments are only taxed once). As we can see by opting for debt financing over equity financing, companies can avoid double taxation. This concept is called the tax shield. The savings of the tax shield can be easily quantified.
Debt Tax Shield Calculation
Tax Shield Savings = Interest Payment * Corporate Tax Rate
Where Interest Payment = Debt * Interest Rate
For example, if a company was making interest payments of £10,000 and the corporate tax rate is 20%, their tax shield savings would be £2,000. Intuitively, we can see that in countries with higher tax rates, firms would be incentivised to raise capital through debt, as the savings from the tax shield would be greater. It is clear that the Tax system of a country will have an impact on how a firm decides to allocate its debt and equity for financing investments.
Advantages of a Debt Tax Shield
Not only does taking on debt benefit the lenders but it can also benefit the shareholders. The savings from the tax shield can be interpreted as future cash flows for the company. This can be discounted to calculate its present value (how much those cash flows are worth today). There are a few different options the company could take to please shareholders. The tax shield savings could simply lead to increased cash dividends to shareholders. Alternatively, the savings could be retained and reinvested to increase the value of the firm, consequently increases the share price. This leads to shareholders realising capital gains as they can sell their shares for a higher price than they bought it. Also, the firm could implement a stock buyback (buying back its own shares from the marketplace). This will boost the prices of remaining shares, resulting in capital gains. From Figure 1, we can see the preference of large corporations to the debt over equity particular in the Telecommunications sector.
Why Equity over Debt?
Why would a firm choose to issue equity as opposed to debt if the tax shield is so advantageous? Why do some investors prefer shares over bonds despite bondholders being taxed less? When a company takes on more debt, they are more likely to default (failure to repay a debt including interest or principal) on those loans. Making highly leveraged firms more at risk of bankruptcy. There are of course huge costs for companies undergoing bankruptcy. The potential legal, as well as administrative costs, would decrease the future value of the firm, affecting the firm and its shareholders. These costs can diminish or negate tax shield savings. Firms seek to optimise their level of equity and debt in order to maximise their value. An investor may prefer owning shares over bonds because they have higher returns. When a firm goes bankrupt, it will undergo the process of liquidation (selling of its assets to claimants). The government (taxes), the lenders, and the employee wages are prioritised, with the shareholders being paid last. In many cases the shareholders receive no payment at all. This makes shares riskier than bonds, meaning investors require a higher return on their investment in order to compensate for this.
Coronavirus Impact on Corporate Debt
This risk of bankruptcy is particularly dangerous in time of uncertainty. With the ongoing pandemic, an article from the Financial Times claimed that ‘coronavirus threatens $32tn of Asia corporate debt’, and that there may be a ‘wave of bankruptcies in industries from airlines to retail’. The aftermath of the global financial crisis saw companies milking the low-interest rates put in place to stimulate the economy. With many firms finding themselves in an overleveraged position. An article by The Guardian stated that expert investors have warned ‘Coronavirus credit crunch could make 2008 look like child’s play’. For those looking for a deeper analysis, I would recommend reading the three articles below:
Financial Times – Coronavirus threatens $32 of Asia Corporate debt:
The Guardian – Coronavirus credit crunch could make 2008 look like ‘child’s play’:
Financial Times – Will the Coronavirus trigger a corporate debt crisis?: