LECTUREPEDIA - Ajarn Paul Tanongpol, J.D.; M.B.A.;B.A.; CBEST
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I.

FINANCIAL STRUCTURE AND INCOME TAX

There are two options available for the firm’s financing decision, namely debt and equity. If the firm issues shares to investors, it is called equity financing. Equity financing is the exchange of the firm’s ownership through issuance of share to investors. Investors buy shares of ownership in the firm. As shareholders, investors will share the profit from the firm’s operation through dividend payment. Another option for the firm to raise capital is debt. Debt occurs when the firm borrows money from bank or investors. There are two types of debt financing; either firm borrows directly from the bank in a conventional loan, or the firm can borrow from investors through issuing bonds.

            The net present value is the criterion used to determine which option is best for the firm. In this section, the expression s refers to the State or Country that imposes tax law, and t refers to time. For purposes of this section, assume the following definitions:

         =          the corporate tax rate;

        =          the personal tax rate of investor i on income from stock;

       =          the personal tax rate of investor i from income from bonds;

=          the current price of security that generate one dollar of dividend (stock income) in (s, t);

       =          Current value of the firm’s stock;

       =          Current value of the firm’s debt;

  =          the firm’s investment in (s, t);

        =          the firm’s current investment which is made by current shareholders or bondholders who provide the initial capital to finance the firm;

=          the firm’s revenue less expenses in (s, t); X(s, t) depends on I(s, t) all s, all j<t, i.e. X(s, t) depends on investment before time t;

=        the firm’s depreciation for tax purposes in (s, t);

=         payments by the firm to bondholders in (s, t); all of  is assumed to be tax deductible; and

=         the firm’s stock returns net of corporate taxes but before personal taxes   on stock income in (s, t); assume initially that all of is paid out as a dividend in (s, t) and taxed as personal income.

            From the above definition, the returns that the firm’s stock will yield can be expressed as:

                        [1.1]

The firm’s value comprises of two components: debt and equity. The money raised through issuing stocks and bonds are summed to make the total value of the firm’s market value. The firm valuation is qualified with the term ‘market’ because the price of its stock bought and sold in the stock market is not constant. The price of the firm’s stock depends on the market’s perception on the firm’s value. The market values of the firm’s debt and equity are:

                                                                                   [1.2]

            The value of the firm’s equity is the product of the price of the current stock in the market multiplied by the net present value of the returns generated by the firm’s stock by means of dividend payment.

                                                                                  [1.3]

            Similarly, the value of the firm’s debt is the product of the price of the current bond in the market multiplied by the net present value of the returns generated by the firm’s bond by means of interest payment. In the debt situation, the investor and firm set on a predetermined amount of return for the initial investment. Bond buyers and firm agreed on the bond rate and the amount of investment. The challenge is to determine what shall be the investment amount to be committed by the firm to yield a maximum amount of bond yield to the investor.

                                         [1.4]

By substituting equation [1], the firm’s goal is to maximize its value by:

                                                                                                                  [1.5]

Subject to the following conditions:

                                                                                                            [1.6]

                                                     [1.7]

From equations [4] to [7], it is apparent that the firm has the flexibility in formulating its capital structure. It can elect to finance its operations through debt or equity. The capital structure alternatives available to the firm are equity, risk-free debt, and risky debt.

(a)   Equity only

                                                                                        [1.7a]

In a case where the firm raises it capital through equity only, the bond equation is set to equal to zero. The firm does not raise any through debt, only issuing stocks.

(b)   Risk-free debt

                              [1.7b]

In a risk-free debt financing, the payment by the firm to bondholders at all time must be equal to or less than net of corporate tax, but before personal income tax of the investor receiving income from the bond yield.

(c)    Risky debt

                                           [1.7c]

In a risky debt alternative, i.e. junk bond, the bond yield is set to equal to the net revenue of the firm adjusted for deductions from depreciation and investment and the corporate income tax rate.

The firm is faced with the market’s perception of its value. The current market price for the firm’s stock and bond is expressed as:

                                                                     [1.8]

            Equation [8] explains that the current market price of the firm is equal to the firm’s dollar of debt returns:  minus the equity returns adjusted for corporate tax rate. It implies that an investor will decide to invest in bonds or stock y comparing the net returns received from the firm. If the investor opted for bonds, the returns from the interest payment from the bonds will be treated as a taxable income. If the investor opted for equity, the dividend payment received will be treated as a stock income. The decision to elect bond or stock will also be determined by the local income tax structure.

            An Investor invests with the hope of securing returns on his investment. The returns is utility investors received from investment. To see how the concept of utility interrelates with investment decision, the following definitions are added into our discussion:

             = individual investor;

          = the investor’s utility from the investment;

          = the unit of current consumption;

         = net personal taxable income in (s, t);

         = wealth

           = tax rate for income from stock;

          = tax rate for income from bond;

 = pretax income received from bond yield; and

 = pretax income received from stock dividend.

            The investor’s objective is to maximize his wealth. Wealth maximization is expressed as:

                                                         [1.9]

In order for wealth maximization to occur, the following conditions must occur: wealth is equal to or greater than zero; personal income tax liability is a sum of tax liability for income derived from stock and bond yields; and current consumption is equal to or greater than zero.

(a)               Wealth is equal to or greater than zero

                           [1.10]

By definition, personal wealth is defined as the sum of current consumption plus income derived from investment. There are two types of investment, namely investment in debt and investment in equity. The accounting of income from debt and equity as components of wealth is self-explanatory. However, the incorporation of current consumption into the calculation of wealth may raise a question. Consumption is expenditure; it does not appear to be sensible to include consumption into wealth. However, in order for the individual to consume, he must have money or disposable income. This disposable income is in his possession outside of the income received from stock and bond. Therefore, the addition of current consumption into the calculation of wealth is consistent.

(b)               Income derived from stock and bonds are taxable

                                [1.11]

            Although there are other sources of income, such as income derived from employment and property rental, the main focus of equation [11] and that of the subject matter under discussion in this paper is income derived through investment in the capital market. These two income sources are treated differently and separately by tax law; therefore, they are selected as a special topic for our discussion.

(c)                Current consumption is equal to or greater than zero

                                                  [1.12]

            The condition for consumption is that either the investor has a consumption which is greater than zero. This condition is pragmatic because actual consumption has a positive amount of expenditure. If there is no consumption, the number is zero. Only these two conditions may hold. Consumption may not be less than zero. If there is no consumption, the consumption amount is equal to zero, it cannot go lower than zero.

            From the above three condition, the investor decides to invest in debt or in equity according to the following conditions:

                                                                                           [1.13]

If the after-tax income received from equity is greater than from debt, the investor will opt for investing in stock. Similarly, if the after-tax income from debt claim is greater than that from equity, the investor will opt for investing in debt.

                                                                                           [1.14]

            In equation [14], it is said that the utility in investing in bond exceeds that in stock. There might be circumstances in which the utility received by the investor in bond is equal to that from stock; in such a case, the investor is indifferent whether to invest in stock or in bond. This situation is expressed by equation [15] below:

                                                                                           [1.15]

Equations [13], [14], and [15] are concerned with a normal investor I; however, not all investors are the i-type. The i-type investor looks at the actual tax liability to decide whether to opt for debt or equity in his investment. There is another type of investor who does not use the actual tax liability, but using the tax rate as the deciding factor whether to invest in debt or equity. This is known as the m-type: a marginal investor.

A marginal investor has the tax rate that satisfies the following condition:

                                                                                   [1.16]

            The firm is indifferent to the preference of debt or equity. As an investment policy, the firm will attempt to limit its cost in bond interest and stock dividend to be at equilibrium. As for stock, dividend will be paid when the firm makes profit. When the firm is not making profit, there is nothing to declare as dividend. In the case of debt, the firm is bound by contractual obligations to pay the bond yield. The yield rate is lower than what the investor will receive under dividend payment. However, dividend payment is not a guaranteed payment.  In both cases, it can be said that that firm is indifferent to bond or equity as a means to raise capital. For that reason, the firm will not differentiate investors into i or m type, but will have one class of investor: j. Therefore, equation [16] is rewritten as:

                                                                                    [1.17]

            The indifference of the firm expressed in equation [17] is known as the clientele effect. Although the firm is indifferent to debt or equity, but in order to cater to clients’ needs as defined by their personal income tax, the firm will make both debt and equity available for investor.

Last modified: 11/11/08