How Frequently Should Companies Pay Tax on Profit

Abstract

AbstractTwo main capital structure theories: Brusov–Filatova–Orekhova (BFO theory) and its perpetuity limit—Modigliani–Miller theory—describe the case of annual payments of tax of profit at the end of periods, but in practice, these payments (1) are made more frequent: semiannually, quarterly, monthly; (2) could be made in advance. To study the influence of these two effects on main financial indicators of the company, such as the weighted average cost of capital, WACC, company value, V, and equity cost, ke, we modify the Modigliani–Miller theory for the case of arbitrary frequency of payments of tax on profit: for payments at the end of periods as well as for advanced payments. Account of two these effects leads to very important consequences. We show that: 1. All Modigliani–Miller theorems, statements, and all formulas change. 2. All main financial indicators, WACC, V, and ke depend on the frequency of tax on profit payments and start depend on debt cost kd, while in ordinary (classical) Modigliani–Miller theory all these indicators DO NOT depend on kd. 3. The tilt angle of the curve of equity cost, ke (L), changes with the frequency of payments of tax of profit p, this modifies the dividend policy of the company, because the economically justified value of dividends is equal to equity cost. 4. For payments of tax of profit at the end of periods more frequent payments of income tax are beneficial for both parties: for the company and for the tax regulator: (1) for the company, this leads to decrease of the cost of attracting capital, WACC, and thus to an increase in the value of the company, V, and (2) for the tax regulator, more frequent payments are beneficial due to the time value of money. 5. For payments of tax of profit in advance more frequent payments of income tax are NOT beneficial for the company: this leads to increase of the cost of attracting capital, WACC, and thus to decrease in the value of the company, V, but for the tax regulator it remains beneficial: earlier payments are beneficial due to the time value of money. All these allow company to choose the method of payments of tax of profit(at the end of period or in advance) and number of payments of tax of profit per year, as many, as it is profitable to it (of course, within actual tax legislation).KeywordsModified Modigliani–Miller theoryFrequency of payment of tax on profitAdvanced payments of tax on profitEquity costThe weighted average cost of capitalCompany value