Interest Expense Research Articles

Comment on Song: Mortgage Interest Deduction

A proper income tax base should allow a deduction for mortgage interest expense, according to Richard Gordon of Case Western Reserve University.

Is the Financial Safety Net a Barrier to Cross-Border Banking?

A bank’s interest expenses are found to increase with its degree of internationalization as proxied by its share of foreign liabilities in total liabilities or a Herfindahl index of international liability concentration, especially if the bank is performing badly. Our benchmark estimation suggests that an international bank’s cost of funds raised through a foreign subsidiary is between 1.5% and 2.4% higher than the cost of funds for a purely domestic bank, which is a sizeable difference given an overall mean cost of funds of 3.3%. These results are consistent with limited incentives for national authorities to bail out an international bank, but also with an international bank recovery and resolution process that is inefficient. In any event, the operation of the financial safety net appears to be a barrier to cross-border banking.

Rating Agency Adjustments to GAAP Financial Statements and Their Effect on Ratings and Bond Yields

Using a dataset of financial statements that are adjusted by Moody's for its credit analysis, I document extensive and large differences between firms' reported U.S. GAAP numbers and firms' adjusted numbers. Off-balance sheet financing accounts for the largest difference. The adjusted leverage ratio exceeds the reported leverage ratio by 20% (70%) for the median (average) firm. Adjusted profitability ratios and cash flow to debt ratios differ from their U.S. GAAP equivalents primarily because of greater adjusted interest expense and greater adjusted debt numbers. This implies that essentially all firms in the sample understate their leverage. In addition to adjusting reported accounting numbers, credit analysts adjust ratings down by an average of 0.38 notches due to credit risk from qualitative factors. I predict and find that rating agency adjustments are associated with greater credit spreads and a flatter credit spread term structure. This implies that credit ratings are a function of quantitative adjustments to U.S. GAAP numbers and the rating agency's qualitative assessment of credit risk arising from soft factors. The results suggest that rating agency's quantitative and soft adjustments capture true default risk and rating agencies efficiently process accounting and soft information. Thus ratings can serve as a contracting device to incorporate off-balance-sheet debt adjustments and credit-risk increasing soft factors.

Profitability, Liquidity and Solvency of Wood Harvesting Contractors in Finland

In order to respond to global competition challenges, the wood-processing industry in Finland and elsewhere is outsourcing roundwood harvesting to harvesting contractors. The industry also seeks to negotiate with fewer, larger and more diverse contractor enterprises. The weak profitability, liquidity and solvency of harvesting contractors and the consequent difficulty in hiring qualified machine operators make networking and enterprise growth a complicated process. Financial data of 1,060 Finnish wood harvesting contractors from the period 2001 to 2007 were studied using the ‘closing of the accounts’ data. The material represents most of the full-time contractors. For 2007 net profit was about 6%, credit share of turnover over 50% and median financial reserve €18,000. High machine depreciation and interest expenses together with low solidity make it difficult for small enterprises to absorb seasonal variations and to cope with recessions. Profitability varies considerably amongst smallest enterprises, which most often are sole-operator enterprises. Moreover, even the median profit of the smallest enterprises tends to be negative, which means that enterprise capital will be consumed and many enterprises are at risk of failure. Larger enterprises are more likely to be limited liability companies. Their median profit is clearly positive and the profit varies relative little between enterprises.

The Valuation of Tax Loss Carryforwards

This paper shows that future tax savings from a tax loss carryforward equal a portfolio of options based on the taxable base. Unfortunately, the assumption of a geometric Brownian motion is not applicable for the taxable base since it implies that a positive taxable base, for example, will never become negative and vice versa. Therefore, the famous Black/Scholes formula cannot be used for valuing this portfolio of options. In order to solve this problem, we assume an arithmetic Brownian motion for the taxable base and derive a formula for valuing tax loss carryforwards within a single-period model. In a multiperiod context, a Monte-Carlo simulation based on our findings provides reasonable results. This methodology can also be used to value the tax shields arising from debt if the interest expenses cannot be used in full during the period in which they occur. Our simulation suggests that the assumption that interest expenses are immediately deductable will yield inadequate company values.

Risky Tax Shields and Risky Debt: A Monte Carlo Approach

I identify three sources of risk for the tax shields: two of them associated to the risk of debt and one associated to the operating risk. I present a set of conditions for defining risky debt associated to cash flow and not to accounting earnings. I explain why realization of tax shields for finite cash flows in any period of time t are correlated to Earnings before Interest and Taxes and are not correlated to interest expenses at time t. I question the validity of Miles and Ezzell proposal.Using Monte Carlo Simulation I explore the behavior of the four basic cash flows, Earnings before Interest and Taxes plus Other income OI, and interest charges, with eight scenarios applied to a financial planning model. I conclude that the risk of tax shields is Ku, the unlevered cost of equity.

Penilaian Kinerja PT Bank X dalam Mengelola Asset dan Kewajiban Berdasarkan Analisis Resiko dan Analisis Return

Performance financial evaluation became a primary indicator for management, especially a bank. This research evaluated asset and liability management of PT Bank X to describe its risk and return, by using financial ratios. The results found that performance ratios of PT Bank X decreasingly, where interest margin and net margin decreased to negative. This because of interest expenses and other operational expenses increased. Risk evaluation based on liquidity ratio were also decreasing in 2006 – 2007, because of the most assets of the bank became illiquid assest and default credits. On the other hand, this conditions became worse because of “Rush”, many of their customers took their money out from the bank on the same period. In 2008, bank has reduced their default credits succesively and made its liquiditiy better than previous year. Bad quality of credit management and control made the bank budgets their bad allowances for default credits higher and made bank’s capital risk higher too. Finally, all of bank’s capital was financed with their liabilities. The other hand, bank’s operating risk were recovered slowly, by organzation rationalization to reduce number of employees, as efficiency also. But this effort, indeed, made employee expenses increasing because management must pay golden-shake hand costs to employees.

AN OPTIMAL MARKET ENTRY/EXIT EVALUATION MODEL WITH PARTIAL FINANCING FUNDS

The paper mainly aims to introduce the real options approach to construct an evaluation model for the firm value under partial financing funds. The paper examines that production volume follows the geometric Brownian motion and considers that both the market entry of investment cost and the market exit of withdrawal cost match the linear function with production volume. Then the paper evaluates the potential firm value before market entry, the operational value with the firm's operating, and the market exit value with the firm's stopping to operate so as to assess the whole firm value, shareholder value, and bondholder value hereafter. The results show that different debt ratios will affect the firm's investment decision. The paper figures out the optimal decision-making based on the maximum profit of shareholders or the maximum profit of shareholders-and-bondholders. The factor is finance leverage; although interest expenses are tax deductible, an overly high leverage may trigger agency costs for a firm, which will offset the tax shields associated with leverage. Therefore, a firm should not leverage too much. Furthermore, the paper constructs an innovative evaluation model in a dynamic-financing environment in order to provide the management team with a decision-making mechanism for their decisions in market entry or market exit in a timely manner in the face of uncontrollable exogenous variables.

Systems analysis of project cash flow management strategies

Cash flow management is one of the most important determinants of the success of construction project management. Overdraft, retainage, financing, payment and billing policies constitute the most significant financial issues that contractors must plan, control and manage for the successful completion of construction jobs. Particularly, in an attempt to reduce project costs, contractors must balance cost savings of material discounts due to early payments and extra interest expenses because of additional overdraft. Through identifying feedback loops in project cash flows, a system dynamics model is developed for project cash flow management. The model is flexible to incorporate typical front‐end and back‐end loading cash flow management strategies and provides an interactive predication of project cash flows. A warehouse project is discussed to demonstrate how various cash flow strategies improve overdraft financing requirements and profitability. Especially, the analysis shows an 11% reduction on overdraft requirements while using an overbilling strategy, and 30% reduction if the trade credit strategy is implemented.

Intangible Assets and Value Creation at Brazilian Companies: An Application for the Brazilian Textile Manufacturing Sector

This paper investigates the relationship between intellectual capital and value creation in the Textile Manufacturing Sector in Brazil. Through the access of the database from the Annual Industrial Research conducted by the Brazilian Institute of Geography and Statistics, we gathered 644 observations, from 2000 to 2006, with more than 100 employees To achieve the goal of the study, we consider intellectual capital as defined by Ante Pulic including human capital and structural capital. For the analysis of business performance, we used Pulic’s VAIC index as a measure of efficiency of the employed financial and intellectual capital. Regression models were run to verify the relationship among the efficiency in the use of intellectual capital and the profitability of Brazilian companies. The gross income, calculated as before selling, general and administrative expenses, depreciation expenses, amortization and interest expenses, was used as measure of the flows of value creation and the profitability was measured by the gross income to the total assets of the companies. We tested the following hypotheses: (i) there is a positive relationship between value creation and intellectual capital, (ii) there is a positive relationship between value creation and stock of intellectual capital, (iii) there is a positive relationship between value creation and efficiency of the employed capital, (iv) there is a positive relationship between value creation and efficiency of the human capital, (v) there is a positive relationship between value creation and efficiency of the structural capital. The results of the study, obtained through panel data analysis and through the use of static models, support the hypotheses that the intellectual capital of the companies, in its flow and stock dimensions, is positively and significantly related to value creation.

Improved capital budgeting decision making: evidence from Canada

PurposeThe purpose of this article is to evaluate current techniques in capital budget decision making in Canada, including real options, and to integrate the results with similar previous studies.Design/methodology/approachA mail survey was conducted, which included 88 large firms in Canada.FindingsTrends towards sophisticated techniques have continued; however, even in large firms, 17 percent did not use discounted cash flow (DCF). Of those which did, the majority favoured net present value (NPV) and internal rate of return (IRR). Overall between one in ten to one in three were not correctly applying certain aspects of DCF. Only 8 percent used real options.Research limitations/implicationsOne limitation is that the survey does not indicate why managers continue using less advanced capital budgeting decision techniques. A second is that choice of population may bias results to large firms in Canada.Practical implicationsThe main area for management focus is real options. Other areas for improvement are administrative procedures, using the weighted average cost of capital (WACC), adjusting the WACC for different projects or divisions, employing target or market values for weights, and not including interest expenses in project cash flows. A small proportion of managers also need to start using DCF.Originality/valueThe evaluation shows there still remains a theory‐practice gap in the detailed elements of DCF capital budgeting decision techniques, and in real options. Further, it is valuable to take stock of a concept that has been developed over a number of years. What this paper offers is a fine‐grained analysis of investment decision making, a synthesis and integration of several studies on DCF where new comparisons are made, advice to managers and thus opportunities to improve investment decision making.

Sequential Impact of General Interest Rate Changes on the Interest Expense of Publicly Traded Restaurant Firms

It is generally known that restaurant firms are very capital intensive, largely due to the significant amount of capital expenditures required to expand. Therefore, restaurant firms are critically dependent upon borrowed capital for financing new locations. This would imply that interest expense is a significant expense for most restaurant firms. Therefore, any changes in the interest rates in the general economy have the potential of having a major impact on restaurant firm earnings, even without an accompanying change in the eating-out behavior of consumers. The interest of this study was in determining the sequential impact of the general interest rates (federal funds target rate) on the firm specific effective after-tax interest rate, which are, in turn, related to the cost of capital of the firm. Empirical evidence on this relationship is provided, along with magnitude and lag information of the relationship. Both short-term and long-term debt, as well as quarterly and annual data of firms, are used. Findings indicate that changes in the federal funds interest rate have small sequential impacts on the effective interest rates for restaurant firms. In other words, changes in federal rates affect the effective interest rates of restaurant firms in a decreasing fashion. The more recent the changes in federal rates, the less the impact on the effective interest rates.

Decision model and analysis for investment interest expense deduction and allocation

Abstract Investment income tax planning requires informed, strategic choices. One must determine the amount of qualified dividends and net long-term capital gain to be included in investment income (against which investment interest expense can be deducted). This choice also determines the residual qualified dividends and net long-term capital gain which enjoy a reduced tax rate. Another important decision is whether all or some of this interest expense should be deducted in the current year or carried forward. This paper puts forward a new approach to formulate these questions as a generalized resource allocation problem which permits analysis of the interdependence between, and the tax consequences of, the above decisions. The commonly used approach – deducting investment interest expense sooner rather than later – we consider myopic since the benefit of deferring some of the deduction is not leveraged. Presented here is a tax planning guideline (a necessary and sufficient condition for optimality) to realize a more forward-looking strategy. We also show that, for certain income structures, the tax savings by deducting a one-dollar investment interest expense may be more than the tax rate on the dollar of investment income that is offset.

Main Drivers of the ECB Financial Accounts and ECB Financial Strength Over the First 11 Years

This paper analyses the main drivers of the ECB’s balance sheet and profit and loss account over the first 11 years of the ECB’s existence. Furthermore, the paper assesses the financial strength of the ECB. As monetary policy operations are normally conducted by national central banks under the impulse and instructions from the ECB, the Eurosystem balance sheet is the primary reference for the analysis of Eurosystem monetary policy operations. Three main drivers of the balance sheet and profit and loss account are identified. Firstly, financial market developments and portfolio management decisions imply changes in the value of the foreign reserve and own funds portfolios, which represent a substantial part of the balance sheet (with the share of own funds becoming increasingly larger over the period under review). At the same time, the profit and loss account depends to an important degree on interest income and expenses, realised gains and losses, and write-downs on these portfolios. Secondly, strong banknote demand has gradually increased the size of the balance sheet since the euro changeover in 2002. Banknotes in circulation also provide a strong base for seigniorage income, which is an important item of the profit and loss account. Thirdly, the liquidity-providing operations in foreign currency, which the Eurosystem has undertaken since 2007 in response to the fi nancial crisis, increased significantly the size of the ECB’s (and the Eurosystem’s) balance sheet. In terms of income and expenses, these operations were rather immaterial at the level of the ECB, although the income generated was substantial at the Eurosystem level. The ECB has remained financially strong over the 11-year period. Factors that support the financial position are strong legislative provisions on e.g. independence and income, the use of financial buffers, seigniorage as a reliable income source and an effective loss-coverage mechanism. JEL Classification: D21, D92, E22, E52

Cost of Capital When Dividends are Deductible (Costo de Capital con Dividendos Deducibles) (Spanish)

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. Tax savings and the discount rate 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.In this paper we develop the formulations for Ke, the cost of levered equity and the average cost of capital when dividends, interest on equity or monetary correction of equity are deductible. This is the case of Brazil.We show that using the proper formulation the most known valuation methods, i) Firm value with Free Cash Flow and WACC for the FCF; ii) value with the Capital Cash Flow and WACC for the FCC; iii) equity value with the Cash Flow to Equity and Ke, the levered cost of equity plus debt; iv) Adjusted Present Value, APV are consistent and give identical results.

Intellectual Capital and Value Creation in the Production and Assembly of Vehicles and Auto-Parts Sector in Brazil

This work investigates the relationship between intellectual capital and value creation in the sector of Production and Assembly of Vehicles and Auto-parts in Brazil. Through the access of the database from the Annual Industrial Research conducted by the Brazilian Institute of Geography and Statistics, we gathered 865 observations, from 2000 to 2006, of public and private Brazilian companies with more than 100 employees. The database allows the estimate of relevant aggregated variables such as national accounts, gross domestic product, intermediate consumption, as well as propitiates a sectorial study of business strategies and performance, including value added by individual companies. In particular, in this study we use data on variables associated to intellectual capital. To achieve the goal of the study, we consider intellectual capital as defined by Pulic (2000, 2002), including human capital and structural capital. For the analysis of business performance, we used Pulic’s VAIC index as a measure of efficiency of the employed financial and intellectual capital. Regression models were run to verify the relationship among the efficiency in the use of intellectual capital and the profitability of Brazilian companies. The gross income, calculated as before selling, general and administrative expenses, depreciation expenses, amortization and interest expenses, was used as measure of the flows of value creation and the profitability was measured by the gross income to the total assets of the companies. Considering the constructs defined by Pulic (2000, 2002), we tested, for the Brazilian sector of Production and Assembly of Vehicles and Auto-parts, the following hypotheses: (i) there is a positive relationship between value creation and intellectual capital, (ii) there is a positive relationship between value creation and stock of intellectual capital, (iii) there is a positive relationship between value creation and efficiency of the employed capital , (iv) there is a positive relationship between value creation and efficiency of the human capital, (v) there is a positive relationship between value creation and efficiency of the structural capital. The results of the study, obtained through panel data analysis and through the use static and dynamic models, support the hypotheses that the intellectual capital of the companies, in its flow and stock dimensions, is positively and significantly related to value creation.

Retirement Arrangements of the Self-Employed

When compared to wage earners, the take up rate of qualified retirement plans by the self-employed seems to be much lower. This paper explores the various factors that influence the observed participation and contributions to such plans. The findings show that participation declines with business interest expenses suggesting liquidity constraints. In contrast, both participation and contributions rise with mortgage interest expenses. They also rise with interest and dividend income, self-employment income, as well as tax rates. On the other hand, they decline with the size of partnership income. The latter is perhaps a reflection of reporting conventions employed by high income partners which may mask the true participation rate.

Critique of the Report of the Advisory Panel on Canada's international tax system

This article presents a critical analysis of the report of the Advisory Panel on Canada's System of International Taxation. The criticism is derived from the author's analysis in his 2009 book on reforming Canada's international tax system. The article focuses on three aspects of the report: taxation of the foreign-source income of Canadian corporations, deductibility of interest expenses, and tax administration and legislation. The article concludes that the report does not provide a thorough, analytically rigorous examination of the most difficult issues facing Canada's international tax system.

Efficiency of Rural Banks: The Case of India

The objective of this paper is to investigate whether the restructuring of regional rural banks in India –undertaken in 1993-94 - has helped improve their production efficiency. Several committees have emphasized the need to improve the efficiency of these banks which are an important arm of the rural credit system in India. Improved production efficiency in provision of services would mean lower cost and financially sustainable operations. Production efficiency has been measured using a non-parametric technique of Data Envelopment Analysis (DEA). To measure efficiency most directly, interest income and non-interest income were used as outputs and interest expenses and non-interest expenses were used as inputs. Efficiency scores were calculated for the years 1990 to 2002. Thereafter these scores were compared for before and after the restructuring year (1993-94). The study finds that efficiency of rural banks has significantly improved after restructuring. It seems the policy of the Government of India to restructure these banks has shown positive results and the study recommends its continuance.

Payment Scale Economies, Competition, and Pricing

Payment scale economies affect banking costs, competition in payment services, and pricing. Our scale measure relates operating cost to physical measures of European banking output, finding large economies. This differs from relating total cost to the value of balance sheet assets (the conventional approach). Interest expenses are excluded since differences here are primarily due to mix, not scale. Also, since standard indicators of competition can give inconsistent results, a revenue-based frontier measure is developed and applied to European banks, with little difference evident across countries. Existing differences in bank prices (EC report) are associated with small differences in competition.