Tax benefit of debt

Hi guys,

I just joined and was hoping you could help answer a few of my questions.

I am trying to understand the benefit of having debt in the capital structure and incurring tax shields as a result of interest expense.

I understand that interest expense lowers the total amount of taxes paid by a firm, but doesn't interest expense still hurt or lower the bottom line of a firm by more than the benefit of the tax shield?

Interest expense is a real cash outflow after all (unlike depreciation).

In other words, isn't the cash saved from lower taxes offset by the cash needed to repay the interest expense?

Hopefully you guys can help me understand the whole benefit of debt tax shields better.

 

Debt is cheaper than equity financing, especially when you take into account the tax shield. Think of it this way: more debt in the capital structure results in a lower WACC which means a higher valuation for the company. A simplistic way of looking at it, but I think it answers your question.

Read this for more information on the theory: http://en.wikipedia.org/wiki/Modigliani-Miller_theorem In particular, look at the section "with taxes."

 

Thanks man, I understand that debt is cheaper than equity because of the risks associated with each form of financing and I also understand the cash effects on TAXES by having interest expense versus not having interest expense, but what I am not sure about is the overall cash effect on the FIRM of having interest expense.

Doesn't the required cash payment of interest expense offset the cash savings from the tax shields?

I can see the tax benefits of depreciation since they don't require a cash outflow, but interest expense does.

 

Depreciation is a cash outflow that you make upfront when your purchase the asset.

And it is pretty obvious that you pay out more in interest than you save on the tax shield, but you choose debt (or equity, etc.) financing because you need to raise capital to expand.

If a company had an unlimited amount of cash then they wouldn't need to sell their own debt (or sell stock) and would simply use cash for future projects.

This is obviously a homework assingment, so go to your professor's office hours to understand this concept.

 

I believe the question being asked is: "Why fund an acquisition with debt when the interest expense from the debt will cause a greater cash outflow than the tax savings accumulated?"

The answer to the above question is that investors and operators are looking to generate the most substantial rate of return per invested dollar possible. So while using debt may decrease the overall return of an investment on a dollars earned basis, it magnifies the return per dollar invested.

This argument holds true whether or not interest expense generates a tax shield. The tax shield generated from debt is just a tax rule that makes using debt more attractive than it would otherwise be.

~~~~~~~~~~~ CompBanker

CompBanker’s Career Guidance Services: https://www.rossettiadvisors.com/
 

stk123, this is not a homework assignment. I wish I could ask a professor.

So if the interest expense is always higher than the taxes saved, what is the benefit of having debt? (Besides the fact that it imposes discipline on cash management)

From a cash flow perspective, wouldn't equity always be the better choice?

 

Every form of capital has a cost associated with it. The cost of debt is its interest expense less the tax shield, but equity has a cost associated with it as well.

The cost of equity is the earnings stream that is paid out to all equity holders, so it does not make sense to have capital structures of 100% equity if the company can be funded with debt at lower costs.

Think of it this way: would you rather issue one more share of stock, and pay out that much more in earnings, or would you rather issue an equivalent amount of debt, and pay the interest expense associated with it? You'll find that typically at low leverage levels, it's more worthwhile to issue debt rather than equity.

Remember that the cost of equity is inversely correlated with the P/E ratio, and is thus dependent on stock prices.

 

To add to killscallion's post, dividends to shareholders (like interest on debt) are also a cash outflow. But they are paid after-tax.

Issuing debt will keep the operating cash flow constant (before investors are paid), but the interest is tax deductible.

Just another way to look at it.

 

Just Google WACC and you will get the answer to your question it is a really simple concept.

Lets assume you own a company worth $100 ($0 cash) and own all 10 shares at $10 each. You have a project that will cost you $100 and payout $300.

You can issue $100 debt and payback $110 at the end of the project and end up with 100+300-110=$290, so company value is now $390.

or

You can issue $100 in stock (10 shares at $10 a share, although in reality the issue price would be different based on this project but this is not a class in advanced corporate finance). At the end of the project your company is now worth $100+100+300=$500>390

...but you now only own half the company so your value is only 250

 
TeddyTheBear:
What do you mean scenario? I am simply referring to the tax treatment of the interest on preferred versus mezz. Basically, can we use NOI to pay for both?

Sorry, thought this was for a model, so was just curious of the scenario. Mezz is tax-deductible so you can use op income, pretty sure preferred is not. However, hybrid preferred is.

 

Ok, yea I thought pref equity wouldn't count. Can you clarify on hybrid preferred? How exactly is it structured? I am working on a model, and I am coming to the idea that our client is better off using mezz instead of pref equity, which is what they are going for. The tax deductions might actually be better.

Array
 
TeddyTheBear:
Ok, yea I thought pref equity wouldn't count. Can you clarify on hybrid preferred? How exactly is it structured? I am working on a model, and I am coming to the idea that our client is better off using mezz instead of pref equity, which is what they are going for. The tax deductions might actually be better.

Sorry, not really that versed in hybrids, so I don't want to try and explain and waste your time -- let me know if that PDF helps? Also, did the client give you guys a reason why they want to go for preferred?

 

First glance id say, NOI (same thing as EBITDA in real estate right?) for mezz int. OK and net income for pfd as it's a dividend out of your net income to shareholders. Not a real estate guy tho.

Guess I'll also add if this for a REIT, then yes you pay both out of NOI as there's not tax shield on your interest expense and everything left over pass through to the LP unit holders.

Ace all your PE interview questions with the WSO Private Equity Prep Pack: http://www.wallstreetoasis.com/guide/private-equity-interview-prep-questions
 
Stringer Bell:
First glance id say, NOI (same thing as EBITDA in real estate right?) for mezz int. OK and net income for pfd as it's a dividend out of your net income to shareholders. Not a real estate guy tho.

Guess I'll also add if this for a REIT, then yes you pay both out of NOI as there's not tax shield on your interest expense and everything left over pass through to the LP unit holders.

Hey Stringer Bell,

Quick question -- if there isnt a tax shield, then wouldn't it be paid from NI for REIT, instead of NOI (isnt NOI pretty much operating income?)? Thanks.

 
ddp34:
Stringer Bell:
First glance id say, NOI (same thing as EBITDA in real estate right?) for mezz int. OK and net income for pfd as it's a dividend out of your net income to shareholders. Not a real estate guy tho.

Guess I'll also add if this for a REIT, then yes you pay both out of NOI as there's not tax shield on your interest expense and everything left over pass through to the LP unit holders.

Hey Stringer Bell,

Quick question -- if there isnt a tax shield, then wouldn't it be paid from NI for REIT, instead of NOI (isnt NOI pretty much operating income?)? Thanks.

Again, not sure how real RE guys go about it, but think about fundamentally. What is EBITDA / NOI / whatever? It's a proxy, actually, it is cash flow in the simplest sense. How much revenue, or credit for it, do you less the cost to make it less support for it. Cash up, cash down, easy.

Here's where D&A, interest, etc. IS line items start to fuck shit up. D&A isn't a cash expense, it's a mechanism the government made up get companies to buy a bunch of shit for their companies and soften the blow of big capex needs. Interest is another helper from the gov. as so companies don't have to give up chunks of their company every time they need to raise capital. Dividends aren't because those interest holders are already in bed w/ xyz company, so who gives a shit?

So for a REIT, they don't have taxes right? They have an exempt status from the government and can pass the tax burden through to the sub's. So from the REIT's perspective, D&A doesn't matter because it really doesn't exist and interest exp is just the cost of using borrowed money (note: do not disregard D&A, the LP's will get super pissed if there's no dep. to offset their taxes). So there's really no such thing as NI in for limited partnership. So, call it what you what you'd like, but without taxes, interest is just another cost (unless you capitalize it, but don't worry bout that for now).

Ace all your PE interview questions with the WSO Private Equity Prep Pack: http://www.wallstreetoasis.com/guide/private-equity-interview-prep-questions
 

I was referring to hybrid securities. Thats preferred equity, but those are issued to the public, so hybrids can't apply to a single property. So basically we have been confused about two type of preferred equities, one which is issued to the public, which are also referred to as hybrids. Then there is private preferred equity, which you can get from PE firms, alternate financing companies, etc.

Yes, the yield is typically higher for mezz, but if the benefits of the tax shield are more, then it makes sense to just go with mezz.

Array
 

Ok let me see if I have this right, and someone please feel free to comment. If the company is not a REIT, I guess it would be better for the owner to become a REIT and let the cash flow through. This way the company does not have to worry about tax and instead they can just pay the preferred equity dividend using NOI, then the preferred holders figure out their tax situation, is this right? I would love to talk to someone more knowledgable about REITs and their tax structures.

Array
 

Under our current monetary system, debt = money, so there is a built-in incentive for banks to loan and companies to borrow.

The government supports the status quo because debt is already cheaper than equity and cheap debt encourages companies to invest which drives tax revenue and creates jobs.

That said, it's difficult to argue with the point that the excess leverage building up to the crisis exacerbated the effects. There is a place for incentives, but they were clearly misaligned.

From a surface reading I think the proposal of a dividend tax break is somewhat flawed. From a rudimentary corporate finance point of view, dividends from capital projects funded by equity are unlikely to be paid out until after the project has completed construction and operating cash flow is positive.

On the other hand, for debt financing, depending on the terms of the loan, interest payments and consequently interest tax deductions kick in relatively earlier, resulting in reduced short term costs.

Under anything but the lowest discount rates, companies will prefer the earlier savings from interest tax deductions to later savings from hypothetical dividend tax breaks due to the time value of money. Moreover, as debt is significantly cheaper than equity to begin with, any compensatory dividend tax deduction scheme would have to be fairly drastic to make the present value of an equity financed project higher than one that is debt financed. This change in the tax code would likely produce distortions of its own, potentially discouraging companies from reinvesting their profits.

That's not to say it's not worth pursuing, but I don't think it's nearly as clear-cut as the OP makes it. On the other hand, debt is already pretty appealing as is, so I could certainly entertain the notion that it needs no further incentivization via the tax code.

 

Not only does it add to the risk in the marketplace, it hurts most of regular Americans by causing more than a few companies to go bankrupt and have to lay off workers. I am really curious to see what the private equity lobbyists would say if there was a bill in Congress to get rid of the interest tax deduction (because that is where most of their profits come from).

Sorry for being ignorant, but what do you mean debt is cheaper? Isn't it just cheaper because of the tax deduction?

What about the argument that if there was no debt bias more people would invest in the stock market and more dividends would be paid - aka putting more money into the economy?

 
BostonKid:
Not only does it add to the risk in the marketplace, it hurts most of regular Americans by causing more than a few companies to go bankrupt and have to lay off workers. I am really curious to see what the private equity lobbyists would say if there was a bill in Congress to get rid of the interest tax deduction (because that is where most of their profits come from).

Sorry for being ignorant, but what do you mean debt is cheaper? Isn't it just cheaper because of the tax deduction?

What about the argument that if there was no debt bias more people would invest in the stock market and more dividends would be paid - aka putting more money into the economy?

Debt is cheaper because the interest rates is lower than the expected return to equity (he's talking about the perspective of the borrower/business owner.

Your last point is incorrect. The money would shift around from debt to equity, but the net investment into the economy would stay unchanged. There wouldn't be more money put into the economy.

 

Debt is not just used by LBO PE funds. Project finance (infrastructure, utilities, etc.) often contains significant debt components. Public and private companies not under PE fund control will still issue debt. I would also dispute your assertion that the majority of PE funds' profits are due to the interest tax shield. The tax shield certainly plays a large role, but generally is less significant compared to revenue/EBITDA/profit growth boosting the underlying equity portion of the investment.

Debt is cheaper than equity even without the tax code break (http://www.investopedia.com/ask/answers/05/debtcheaperthanequity.asp). Equity financing dilutes or diminishes the holdings of the original shareholders, lowering their ROE.

Moreover, equity is a riskier form of financing than debt (from the investor's perspective) as it has the lowest seniority of any portion of the capital structure. It would take sweeping reforms across the entire financial system for banks to prefer to invest their capital rather than lend it.

 

What value do private equity firms add to the economy? Nothing. Most of their profits and outlandish compensation come in the form of the tax shield and being able to cut costs.

While I agree that some companies may need new management to ensure they do not grow complacent and to cut inefficencies out, leveraging companies up isnt the only way to accomplish this.

 

Take a look at the big picture.

Companies are given an incentive to use debt funding through the interest tax deduction. This gives them the incentive to use more debt financing to fund their operations, as opposed to equity financing. If it cost the same to do equity or debt financing, more firms might use equity financing, thus diminishing shareholder value. They are also able to borrow to scale up their operations. Finally, debt is less risky than equity, so to create a more stable society, firms should be given an incentive to use debt financing.

On the other hand, individuals are given incentives to purchase stock. Dividends and capital gains tax rates are about half the rate for interest income.

Because of this tax structure, firms issue and investors (individuals with savings) demand both types of securities, building a nice mix of both.

looking for that pick-me-up to power through an all-nighter?
 

Interest is a cost of doing business. Calling it 'forfeited revenue' from a tax standpoint is as misleading as you can get. It's the same idea as us taxing business profits instead of business revenue and calling that difference 'forefeited tax revenue'.....it's just plainly idiotic.

Plus, mortgages are only deductible for the first million dollars or so in the US, so it will hit the middle class and upper middle class much harder than the wealthy who either pay cash or don't get a large deduction from their mortgage.

This kind of thinking is extremely frustrating.

 

OP.. you make a decent point but you also need to consider the purpose a tax subsidy serves. Think of subsidy as an incentive for financing through debt. The pros are less speculation because debtors worry about credit risk of the issuer. Also, debt forces the issuer to face "reality" more often because they have to meet their interest payments on a regular basis. That is not to say that debt levels cannot & should not be reduced.

 

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