Tax Considerations

Taxation implications, which change when using equity or debt for financing, play a major role in deciding how the firm will finance assets. Tax considerations have a major effect on a company's determination of its capital structure and management of its costs of capital.

Two yellow road signs on a pole against a blue sky. One has a dollar sign, the other says "TAXES.

Taxes A company's decision-makers must consider taxes when determining a firm's capital structure.


Miller and Modigliani assume that in a perfect market, firms will borrow at the same interest rate as individuals, there are no taxes, and investment decisions are not changed by financing decisions. This leads to the conclusion that capital structure should not affect value.

When the theory is extended to include taxes and risky debt, things change. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then, would be to have virtually no equity at all.

However, in real-world markets, capital structure does affect firm value. Therefore, imperfections exist; often, a firm's optimal structure does not involve one hundred percent leveraging and no equity whatsoever. There is much debate over how changing corporate tax rates would affect debt usage in capital structure.

In general, since dividend payments are not tax deductible, but interest payments are, one would think that, theoretically, higher corporate tax rates would call for an increase in debt usage to finance capital relative to the usage of equity issuance. However, since many things fall into tax applicability, including firm location and size, this is a generality at best.

Different kinds of debt can also be used, and they may have different deductibility and tax implications. That is why, while many believe that taxes don't really affect the amount of debt used, they actually do. In the end, different tax considerations and implications will affect the costs of debt and equity and how they are used relative to each other in financing a company's capital.

Key Points

  • Tax considerations have a major effect on the way a company determines its capital structure and deals with its costs of capital.

  • Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all.

  • In general, since dividend payments are not tax deductible but interest payments are, one would think that, theoretically, higher corporate tax rates would call for an increase in usage of debt to finance capital, relative to usage of equity issuance.

  • There are different kinds of debt that can be used, and they may have different deductibility and tax implications. This will affect the types of debt used in financing, even if corporate taxes do not change the total amount of debt used.

Terms

  • Interest – the price paid for obtaining, or price received for providing, money or goods in a credit transaction, calculated as a fraction of the amount or value of what was borrowed.

  • Dividend – a pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).

  • Optimal Capital Structure – the amount of debt and equity that maximizes the value of the firm

Back to '7.2: Cost of Capital, Capital Structure, and Weighted Average Cost of Capital\'