Custo de capital quando os dividendos sao dedutiveis.
| Autor | Velez-Pareja, Ignacio |
| Cargo | Texto en inglés |
Cost of Capital when dividends are deductible
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Introduction
Since the seminal contribution of Modigliani & Miller (1963) the value of Tax Savings, TS, has been recognized by the literature. Most of the analyses, including Modigliani & Miller (1963), have focused on the Tax Savings of Debt. One exception is DeAngelo & Masulis (1980) that consider TS due to investment incentives and depreciation. When calculating Tax Savings, TS, we are confronted with a strange mix of accounting accrual and market value when involving TS in the calculation of the Weighted Average Cost of Capital, WACC or the Cost of Equity, Ke. Firms earn the right to TS once they accrue the interest expense and they actually earn the TS when taxes are paid (Velez-Pareja et al., 2008).
Tax savings and the discount rate (¡A) we use to calculate their value are involved in the calculation of WACC and Ke. Textbook WACC formulation is a very special and unique case that is not typical. Based on previous findings, we derive a general approach to those formulas that take into account any kind of TS related to the financing decision of a firm and any date when the TS is earned. These formulations can be used to introduce any type of externality that creates value through tax savings not captured by neither the cost of debt nor the cost of equity.
Taggart (1991) developed some expressions with these purposes. He considers corporate and personal taxes; we only consider corporate taxes. There is no derivation of the formulas in his work. Inselbag & Kaufold (1997), use the same expressions to compare different discount methods to value a firm. Tham & Velez-Pareja (2002) and Tham & Velez-Pareja (2004) derive the proper formulations for Ke and WACC. Velez-Pareja (2010) use these derivations to incorporate the effect of losses in exchange rate, of losses carried forward, of unpaid taxes, of Presumptive Income Taxation and the effect of inflation adjustment of book value of equity when adjusting financial statements by inflation in tax savings. We derive the explicit and general formulation to include other sources of TS and their discount rate, [[psi].
These refinements for calculating Ke and WACC are based on Modigliani & Miller propositions and they are just a tuning up of them to include idiosyncratic conditions found in different markets. In this paper we study the impact of any new source of tax savings. In particular, we study the specific case of Brazil, one of the major economies in the world, which allows a partial deduction of dividends in the Profit and Loss statement. Some other countries also allow (or allowed) the partial deduction of dividends, such as Iceland, Czech Republic and Germany. Although the tax deduction we consider here is novel, and absent in previous works, the basic ideas posed by M&M are the same. However, when valuing firms or projects in such environments (e.g. Brazil, Ireland, etc.) our model captures a source of value previously ignored.
When Brazil used to adjust the financial statements by inflation, they (as many other economies) allowed for adjustment of book value of equity using an index linked to the inflation rate. According to Zani & Ness (2001) after many years of inflation adjustment with a charge equal to the adjustment of book value of equity, since January 1, 1996 firms were allowed to charge interest on the book value of equity and had not only the effect to be a deductible charge, but to pay those interest expenses as part of the dividends defined by the firm. (1) What initially was an accounting accrual figure now is now an actual payment to shareholders with the associated tax savings benefits as before.
In the financial report of a Brazilian firm, Aracruz Celulose (2) to the U.S. Securities and Exchange Commission, they say:
As of January 1, 1996, Brazilian corporations are allowed to attribute interest on stockholders' equity. The calculation is based on the stockholders' equity amounts as stated in the statutory accounting records and the interest rate applied may not exceed the long-term interest rate ("TJLP") determined by the Brazilian Central Bank (approximately 9.75%, 7.78% and 6.32% for years 2005,2006 and 2007, respectively). Also, such interest may not exceed the greater of 50% of net income for the year or 50% of retained earnings plus income reserves (including those mentioned above), determined in each case on the basis of the statutory financial statements. The amount of interest attributed to stockholders is deductible for corporate income tax purposes. (3) Non-traded stock corporations may pay interest on equity JSCP by its initials in Portuguese. The long term interest rate ("A Taxa de Juros de Longo Prazo--TJLP" in Portuguese) is not a market rate. It is established by the National Monetary Council (Conselho Monetario Nacional) and used for loans by the BNDES. "The Brazilian Development Bank (BNDES) is a federal public company, linked to the Ministry of Development, Industry and Foreign Trade (MDIC). Its goal is to provide long-term financing aimed at enhancing Brazil's development, and, therefore, improving the competitiveness of the Brazilian economy and the standard of living of the Brazilian population." (4)
This practice, apart from the adjustment for inflation that was made on an accrual basis, is unusual in the sense of becoming an actual payment, a cash flow. This is not a new cash flow, but it is part of the dividends defined by the firm and yet, they are deductible and hence, the firm earns TS on that. Although the deduction was created as a compensation for the mainly negative result of the inflation adjustment in the income statement, it had unanticipated consequences on the valuation of firms. Damodaran (2003) studies a proposal similar in spirit to the one we study. In 2003 the Bush Administration in its economic package, proposed that the full amount of dividends would be deductible, in order to eliminate double taxation of dividends. By allowing corporations to deduct its dividend payments, taxation would be assumed by the shareholders. Additionally to discuss the effect on cash flows and discount rates, Damodaran speculates that this change would induce firms to be more equity financed (if not entirely), to reduce their cash balances and pay more dividends. (5)
Our results point out that this regulation should have empirical consequences similar to those envisioned by Damodaran (2003). Firms working in such environment are more valuable for their owners and should be less leveraged, as a simple trade-off model proves it. While empirical analyses are in order, the macro economic consequences of such regime are also worth of discussion. As the appetite for debt is reduced, the costs of financial distress will also fall, reducing the economic impact of failed firms for the society, while at the same time increasing the propensity for new ventures, by lowering the risk assumed by the owners.
Different authors have tackled non debt deductions, DeAngelo & Masulis (1980), take Miller's irrelevance model (1977) and postulate that the existence of debt-unrelated tax shields, such as investment tax benefits or depreciation, create optimum financing conditions, even without considering debt-related bankruptcy costs. The existence of these shields reduces the optimal level of financial leverage. Our analysis, considering bankruptcy costs, reaches a similar conclusion when a dividend tax shield is allowed. Graham & Tucker (2006) study US cases where firms engaged in allegedly illegal practices, they document a reduction in financial leverage when companies make use of tax shelters and report fictitious losses.
In a different venue, Rao & Stevens (2007) argument that previous analyses on capital structure ignore the third claim on the firm cash flows, concentrating on the creditors' and shareholders' claim. They develop a model which also values the government claim on the firm, shedding light on the appropriate rate of discount for a firm's debt, and the different tax shields a firm can have. They value non-debt tax shields (depreciation) using, what they call the approximate APT and contend that the appropriate discount rate for the debt is Kd. (6)
The work closest to our own is Zani & Ness (2001) that consider the effect of deductible dividends ("Juros sobre o capital proprio") on Brazilian firms' leverage. They modify the Miller's (1977) irrelevance model with personal taxes to include two additional terms, the extra cash flow received by the dividend tax shield and the bankruptcy costs. Assuming perpetual and constant cash flows and that the appropriate discount rate for the dividend tax shield is the unlevered cost of equity (Ku, per our terminology, see section 2), they calculate the extra value the share holders get because the deductible dividends and a modified expression to evaluate the debt advantage for Brazilian firms. Under the tax rates of 1998, they find that the attractiveness of debt is significantly reduced after the introduction of the new regulation. Their empirical tests, however, do not find evidence of a reduction in leverage after some Brazilian firms initiated the payment of deductible dividends (JSCP) even though its fiscal burden was reduced. Our work complements Zani & Ness (2001) work in two important ways. First, we develop a workable set of equations for valuation purposes that not rely in perpetual and constant cash flows; neither have we assumed that the appropriate rate of discount for the deductible dividends is the unlevered cost of equity. Second, we show a general expression for the debt tax shield for perpetual and constant cash flows that includes personal taxes and the adjustment for deductible dividends.
The rest of the paper is organized as follows. Section 2 introduces the framework and develops the...
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