is the tax shield to blame for the problems with credit

Discussion in 'Economics' started by morganist, Mar 29, 2009.

  1. companies can get a tax shield (tax claim) if they have a higher debt capital to equity capital. they can claim interest on debt against taxable profit but they cannot do the same with dividend payments. it is therefore advantageous to have more debt in capital structure.

    has this created the problems with business credit by overextending the debt equity gearing ratio. also the value of the company and the return is worked out with the weighted average cost of capital to find the beta parameter to put in the capm model. thus by damaging the beta parameter through having large debts the company value calculation is lower on paper affecting the stock market.

    is the tax shield a major contributor to this problem in credit and equity.

    if you want to know more about the tax shield the wacc and the capm follow the link.
  2. it interests me no one has viewed their point yet on this statement it has been up for a while.

    i guess few of you understand corporate banking or the importance in a credit crunch and the affect that has on equity too.

    also due to the affect on equity the value can drop for companies more than the actual worth and can create ideal conditions for mergers and acquisitions plus asset stripping. if you buy shares you will need to understand this point to prevent loses or make gains.

    this will be seen in the future and will impact on you.

    it interests me none of you are commenting on such an important post for you. is it you are not familiar with cb or do you lack agreement with me.
  3. it interests me that no one has commented on this. is it a bad post? i would have thought it was very relevant to you if you invest in shares and calculate their value.
  4. sjfan


    No one answered it because those of us who do know corporate finance can easily dismiss your idea as wrong.

    For the most part, companies heading into the recession were not heavily levered. Especially not compared to the leverage of the structured products. Those products are the toxic assets on banks' book that make it difficult for them to lend.
  5. perhaps it is different in america but in england companies were and are heavily geared. it is also difficult to tell the debts of companies due to off shore accounts hiding debts. also in your point you stated that the banks have the problem because they have bad debt on their books but a lot of that bad debt came from companies that high levels of debt a large percentage of which were hidden on offshore accounts (although that would negate my point slighlty as it is not shown in the capm calculation).

    do you not see the problem with the wacc and the capm calculations in the current environment low credit or expensive credit damaging the beat parameter entered into the capm calculation. really this surprises me.
  6. sjfan


    No. I don't. I'm not entirely sure why it matters. Debt has a slight advantage in terms of WACC because of interest is tax deductible... but why does it that really matter? In no way does it imply that companies should go nuts on debt. And they don't. (see point about convents in the paragraph below the next).

    Moreover, I don't know where you are going with the CAPM... CAPM makes no statement about optimal debt/equity blend... and it makes no statement about debt financing costs... in corporate finance, it's only used (sometimes) to compute the required return of equity.

    I haven't a clue what you mean about "beat" the wacc... why would a company want to beat a wacc? Is your point that company's uses too low of a wacc to determine whether they should enter into a new project? if so, you have a very simplistic view of corporate planning. The tax "shield" doesn't build in any signifiant amount of leverage (try it out - work out a WACC with an without tax deduction... no biggy). Moreoever, what does that have to do with the current liquidity problems?

    And your point about companies being behind structured products isn't really valid. Granted, there are CDOs on corps that in trouble, but those are few and have not created any systemic issues. Moreover, corporate debt issuance is constricted by convents.
  7. OK i meant beta not beat. typo.

    the debt to equity is reflected in the beta of the capm model, which as you correctly pointed out is used to work out the required return from equity. if one aspect of that calculation is altered due to the debt to equity ratio shown in the beta parameter in the capm it alters the required return from equity and as a result the required return from equity investments which can influence investment decisions.

    my point being the tax shield would have and was used to reduce corporate costs when debt was easy to get. in relation to do people use these calculations yes all the time. companies continually use calculations like these you might not see them in the books of the company but if you worked for one then you would see these calculations are done all the time when businesses want to expand, when they want to cover any expense or long term project and they would have to produce business plans to investors or banks to get the finance, so it is not just done it is pretty much required. ALL BUSINESS PLANS show numerical data to back up their plans when they enter a new market or expand on their current one. Whether you would see that is a different matter it may only be the board, the banks the investors that see these reports but they are considered and done.

    so to reply to your comment the capm is very important for equity investment as it calculates teh required return and whether it is worth it or not for an investor. the wacc is used to work out the capm and the wacc is affected by the tax shield. to further my retort finance schools would not base two or three modules a year to corporate finance calculations unless they were used in practice. believe me if you are not using the calculations to work out whether the corporation is well structured and the risk involved in the company due that the risk that it provides either from having too much debt (the current problem) or too little debt (not taking advantage of the tax shield) you are not evaluated your risk when you buy shares. that might not apply to you if you are not buying share (perhaps you buy other things commodities, bonds etc) but if you were buying shares it is a must do to control risk.
  8. sjfan


    First, I think you are mixing up the concepts of WACC and CAPM. CAPM is used to derive an input into WACC: the equity input. Debt cost is a parallel input that does not assume CAPM. So, while I see you have a problem with debt cost in relations to WACC, I don't see what problem you have with CAPM. CAPM does not take debt into account.

    Second, I find it a little silly that your entire argument on why WACC matters (which it does, but not in the way you think) is because business schools devote a lot of time to it. I assure you, as someone who has gone to a top tier business school and employed in a segment of the investment business that make use of such concepts, that the basic WACC is rarely used beyond a simple reporting number.

    Third, while I see your point that a low debt cost implies a low total cost of financing and therefore create for capex, I don't see why "tax shield" is "to be blamed". The leverage effect of the tax shield is tiny compared to all the other factors.

    So, if you want to argue that in the last few years debt has been too cheap, that's true. I don't think corporate debt is what got us in trouble, but sure - at least you are making a reasonable suggestion. But the tax shield as the blame is unreasonable to the extreme.

  9. People are the problem
  10. sjfan


    Thank you for your useful contribution to this discussion. Have you any more insights for us? Perhaps pointing out the sky is blue, or the earth is round? Or some other quip that adds no value whatsoever?
    #10     Mar 30, 2009