Interest Tax Shields Research Articles

Nonprofits and C Corporations: Performance Comparison

We extend the performance comparison study of nonprofits (NPs) and pass-throughs by examining large NPs and large C corporations (CCs). Unlike that study, we also examine performance outcomes under two different tax shield policies. We use the Capital Structure Model as our main methodology. Our purpose is to compare large NPs with large CCs in terms of debt choice, valuation, leverage gain, and growth-related outcomes. All tests considered, NPs (compared to CCs) have a 34.90% valuation advantage; achieve a 78.12% greater increase in value when going from nongrowth to growth (using a 12.34% lower plowback ratio and 10.97% less in retained earnings); attain a 2.56% greater optimal leverage ratio; and, realize 10.97% less in dollars added from debt. We show that switching from an interest tax shield to a retained earnings tax shield increases CC value between 1.35% and 3.28%. The NP value limit is only 0.42% since NPs pay little taxes. Our findings are value-additive for the comparative ownership form research.

Valuing the Interest Tax Shield in the Central European Economies: Panel Data Approach

Capital structure is one of the most frequently discussed issues within Corporate Finance Theory. Optimizing the capital structure and value of the tax shield through the evaluation of its interests can lead to the increasing value of the enterprise, followed by the rising competitiveness and flexibility. The aim of this study is to provide a novel look at the value of the interest tax shield and its determinants in the emerging economies of the Visegrad Four. The model was created on a net sample of nearly 7,000 profitable enterprises between 2015 and 2019 using a one-way fixed effects model of panel data. Regional model results show five main determinants of the debt tax shield (Tangibility, Current Ratio, Gearing, Cost of debt and Size). Others, such as non-debt tax shield, business growth or profitability, are regional, and their impact varies depending on the economic conditions of the countries. The direction of influence of the main determinants indicates that, contrary to the assumed trade-off theory, profitable companies manage the capital structure and the value of tax shield according to the pecking order or modified pecking order theory. The tax shield is made up mostly of interest on short-term loans, which increases the risk of financial distress. There is a hierarchy of funding sources, from trade credit, through shortterm loans, to long-term loans, which are used in the analysed firms to the smallest extent. The structure of liabilities may be considered another determinant of the debt tax shield.

Testing the pecking order theory of capital structure in an Islamic legal system: the case of Saudi Arabia

PurposeThe purpose of this paper is to examine whether the basic premises according to the pecking order theory (POT) provide an explanation for the capital structure mix of firms operating under Islamic principles.Design/methodology/approachPooled ordinary least squares, fixed and random effects regressions were performed to test the POT applying data from a sample of 66 Islamic-compliant firms listed on Saudi Stock Market over the period 2006–2016.FindingsThe results show that sale-based instruments (Murabahah, Ijara) track the financial deficit quite closely followed by equity financing and as a last alternative to finance deficit, Islamic-compliant firms issue Sukuk. In the crisis period, these firms seem more reliant on equity, then on sale-based instruments and on Sukuk as last option. The study findings also indicate that the cumulative financing deficit does not wipe out the effects of conventional variables, although it is empirically significant. This provides no support for the POT attempts by Saudi Islamic-compliant firmsResearch limitations/implicationsThis research contributes to the theory of capital structure in re-validating the findings of a previous theoretical and empirical study. It helps understand the capital structure of Islamic-compliant firms in comparison with conventional firms. It highlights some areas where further research on topics related to capital structure of Islamic-compliant firms is needed. The failure of the POT to explain Saudi firms’ financing choices strongly pushed researchers to test the market timing theory for the Saudi Stock Market. Further research studies could re-examine the trade-off theory in the absence of interest tax shield as in an Islamic economy.Practical implicationsFrom a managerial perspective, this research can serve firm executive managers in their financing decisions to add value to the companies. Furthermore, policymakers, bankers and standard-setting organizations should undertake more collective work to simplify the process of issuing Islamic financial instruments including Sukuk. Moreover, the Saudi Government has to encourage the private sector to be more innovative in developing products and services that are in line with Sharia principles. Finally, to attract investors, the Capital Market Authority has to encourage transaction, efficiency and liquidity of Islamic financial instruments.Originality/valueThe proposed study presents several originalities. First, it explores the implications of relevant Islamic principles on financing preferences of Saudi firms. Second, the present study enables us to investigate what the sudden abundance of liquidity, generated by the record levels of oil prices, implied for the firms’ financing behavior. Finally, it provides further evidence on the impact of financial crisis on the firms’ capital structure choice in a period of considerable slowdown in the world.

Does Removing Interest Tax Shield Decrease Corporate Debt? Evidence From The 2017 US Tax Reform

Tax advantage of debt has been the cornerstone of corporate finance since the beginning. Nonetheless, providing empirical evidence for the relation between tax incentives and corporate debt has been challenging because of a variety of endogeneity issues. This paper uses a unique feature of the 2017 US tax reform to study this relation. The reform reduces the tax advantage of debt for all but a group of exempted firms. Firms that lose interest deductions significantly reduce corporate debt in the year following the tax reform.

CEO AGE AND THE DYNAMIC CAPITAL STRUCTURE EVIDENCE FROM MALAYSIA

This paper aims to investigate the dynamic capital structure of Malaysian firms from upper echelon perspective. Specifically, we test the speed of adjustment towards the target leverage and the age of Chief Executive Officers (CEOs) as a determinant of dynamic capital structure. Utilisation of the System Generalized Method of Moments finds 33.93 of% speed of adjustment for Malaysian firms. The CEOs age is also found to be inversely related to both the optimum leverage and speed of adjustment towards the optimum leverage. As the CEOs age increases, the optimum leverage and speed of adjustment decrease. Our results are robust using the long-term leverage while controlling several firm characteristics that are known to impact the firm’s capital structure, year of effect, and industry fixed effect. The results suggest that CEOs age is a potential factor of Dynamic Capital Structure decision. The findings also highlight the failure of older CEOs in maximising the benefits of debt interest tax shield which prompts higher financial costs and lower firm value. The practical implication of our study lies on the need to attentively look at the CEOs age while hiring a qualified CEO that could improve the firms’ performance.

Tax Deductibility of Interest under the ATAD in Investment Decisions

In 2019, the Czech Republic implemented some of the provisions under Council Directive (EU) 2016/1164, also called the ATAD (Anti-Tax Avoidance Directive). Since then, professionals in the field have been following the impact of this directive on tax legislation and accounting. However, this paper aims to show that in addition to the tax rates and the profit after tax, the ATAD will also impact financial management, specifically investment decision-making. The paper analyses a model situation based on the implementation of these regulatory measures and focuses on the effects of the new EU legislation on the interest tax shield and the overall borrowing costs. The methodology used in the paper is described in more detail in section 2 (“research commentary”) and is based on comparing the net present value of an investment financed with debt capital before and after the ATAD implementation. The calculations use the accounting data of an existing company including information that is not available to the public. This example is used to demonstrate the point by calculating the net present value with regard to the impact of the interest tax shield based on the method of financing. The calculations in the paper follow the applicable rules used in the Czech Republic before and after the ATAD came into force. The results confirm that the net present value (NPV) of investments have decreased. Due to the default parameters set for the calculation, the results also show a comparable decrease in the NPV when the investment is financed with debt capital. With comparable conditions and initial parameters (i.e. zero down payment and identical borrowing costs), the decrease in the NPV is higher when the investment is financed with a bank loan. The analysis shows that investment planning under the new legislation will be more complex and will have to take into account the financial results of the whole firm and whether the borrowing costs are tax deductible. All in all, this analysis suggests that economic calculations have to focus more on the details and the wider context of the tax deductibility of interest.

Is the Value of the New Business Tax Shield Lower? Comparative Study of International Valuation Methods

The macroeconomic environment has been characterized by strong GDP growth in recent years. The favourable conditions allow the growth of new innovative businesses (start-ups), which support multiplier economic development. New businesses are often unprofitable in the first years of existence; there is a higher probability of default. The issue of start-ups may be insufficient funding, high costs of financial distress and resulting low corporate value and unattractiveness for investors. The aim of this paper is to analyse and evaluate which of the existing methods of quantifying the debt tax shield is suitable for start-ups. Three different approaches have been chosen to calculate the interest tax shield; Modigliani-Miller (1963) model for imperfect capital markets and two models from Velez-Pareja (2013,2016). The results were obtained by correlation analysis of more than 5,000 Slovak businesses, the impact of the age of the business on the value of tax shield was examined. Also, the impact of the industry on the value of tax shield was explored. The results of the analysis suggest that the quantification by Modigliani-Miller (1963) formula does not take sufficient into account of the age of company. In contrast, the Velez-Pareja (2013, 2016) models are suitable for start-ups, because they take into account the potential tax shield, which occurs when the operating income cannot cover financial costs (especially interest paid). In innovative industries, start-ups often do not reach the traditional tax shield, but their value may be higher using an alternative formula by Velez-Pareja.

Quantifying the Interest Tax Shield for Different Investors in South Africa

Quantifying the Interest Tax Shield for Different Investors in South Africa

Toward better measurement of financial performance: A robust OEVA–TEVA alternative to biased EVA

We demonstrate analytically and illustrate with examples that the conventional measures of the residual operating income such as the Economic Value Added (EVA) are biased by design and so may yield a misleading assessment of financial performance. Fundamentally, the magnitude of the measurement error depends on the amount of realized interest tax shields and the book to value ratio. Other potentially significant sources of distortions induced by the EVA design are identified as well. We propose a robust alternative that is a concurrent evaluation of the firm’s operating and total performance by means of two related metrics, the Operating EVA (OEVA) and the Total EVA (TEVA). Coherent implementation of the OEVA–TEVA technique is simpler than the EVA both analytically and computationally. It is also able to provide additional information for the management decision making. The overall consistency of the OEVA–TEVA approach is supported by a formally proved equivalence of the corresponding OEVA–TEVA valuation model to the fundamental valuation by the cash flow discounting.

Determinants of Debt Structure in Ace Market Busr Malaysia: A Panel Data Analysis

This study was conducted with the aim to examine the relevance of different financing theories namely Agency Theory, Trade-Off Theory and Pecking Order Theory to explain capital structure choices among firms in “Access, Certainty, Efficiency” (ACE) Market of Bursa Malaysia. The ACE Market is the financing source for the high-growth and technology requirements of middle-sized firms. The literature on debt policy decision making in the ACE market have been scant, leading the scholars to realize the necessity of performing more studies in this field. To further explain this issue, this study performed a quantitative analysis on a panel data sample of 60 ACE firms from 2005 to 2016. Three proxies for leverage namely total, long-term and short-term debts were examined based on the total assets and equity in six regression models. From seven variables examined in this study, findings indicated a significant relationship between warrant and debt in all models. In addition, liquidity, firm size, profitability and leverage showed significant relationship in all the models except for long-term debt. However, reputation, non-debt tax shield and interest tax shield were seen significant in some models. Trade-off Theory and Pecking Order Theory can jointly clarify determinants of firms’ capital structure in the ACE Market.

Does the interest tax shield align with maqasid al Shariah in finance?

The debt-equity distinction is critical in modern corporate finance. We assess the compliance of the interest tax shield with the maqasid al Shariah in finance. For our analysis, we use the ends of maqasid al Shariah as proposed by Akram Laldin & Furqani, 2013. We develop a survey questionnaire to survey an international sample of well-informed individuals in the field of Islamic economics and finance. We use mean comparison, exploratory factor analysis (EFA), and structured equation modeling (SEM) to evaluate 176 responses. Our results reveal that experts consider the interest tax shield as anathema to the ends of maqasid al Shariah in Islamic finance. We find that the interest tax shield discourages equity financing and hinders the objective of overall human well-being. We recommend reframing the tax shield in favor of equity financing to promote profit and loss sharing.

Gross and net tax shield valuation

PurposeThe purpose of this paper is to show that distinguishing between gross and net tax shields arising from interest deductions is important to firm valuation. The distinction affects the interpretation but not valuation of tax shields for the famous Miller’s (1977) model with corporate and personal taxes. However, for the well-known Miles and Ezzell’s (1985) model, the authors show that the valuation of tax shields can be materially affected. Implications to the cost of equity and optimal capital structure are discussed.Design/methodology/approachThis paper proposed a simple tax shield clarification that distinguishes between gross and net tax shields. Net tax shields equal gross tax shields minus personal taxes on debt. When an after-tax riskless rate is used to discount shareholders’ tax shields, this distinction affects the interpretation but not valuation results of the Miller’s model. However, when the after-tax unlevered equity rate is used to discount tax shields under the well-known Miles and Ezzell’s (1985) model, the difference between gross and net tax shields can materially affect valuation results. According to the traditional ME model, both gross tax shields and debt interest tax payments (i.e. net tax shields) are discounted at the after-tax unlevered equity rate. By contrast, the proposed revised ME model discounts gross tax shields at the unlevered equity rate but personal taxes on debt income at the riskless rate (like debt payments). Because personal taxes on debt are nontrivial, traditional ME valuation results can noticeably differ from the revised ME model to the extent that after-tax unlevered equity and debt rates differ from one another.FindingsFor comparative purposes, the authors provide numerical examples of the traditional and revised ME models. The following constant tax rates and market discount rates are assumed: Tc=0.30, Tpb=0.20, Tps=0.10, r=0.06, and ρ=0.10. Table I compares these two models’ valuation results. Maximum firm value for the traditional ME model is 7.89 compared to 7.00 for the revised ME model. At a 50 percent leverage ratio, equity value is reduced from 3.71 to 3.49, respectively. Importantly, the traditional ME model suggests that firm value linearly increases with leverage and implies an all-debt capital structure, whereas firm value stays relatively constant as leverage increases in the revised ME model. These capital structure differences arise due to discounting debt tax payments with the unlevered equity rate (riskless rate) in the traditional ME (revised ME) model. Figure 1 graphically summarizes these results by comparing the traditional ME model (thin lines) to the revised ME model (bold lines).Research limitations/implicationsTextbook treatments of leverage gains to firms or projects with corporate and personal taxes should be amended to take into account this previously unrecognized tradeoff. Also, empirical analyses of capital structure are recommended on the sensitivity of leverage ratios to the gross-tax-gain/debt-personal taxes tradeoff.Practical implicationsFinancial managers need to understand how to value interest tax shields on debt in making capital structure decisions, computing the cost of capital, and valuing the firm.Social implicationsThe valuation of interest tax shields in finance is a long-standing controversy. Nobel prize winners Modigliani and Miller (MM) wrote numerous papers on this subject and gained fame from their ideas in this area. However, application of their ideas has changed over time due to the Miles and Ezzell’s (ME) model of firm valuation. The present paper adapts the pathbreaking ideas of MM to the valuation framework of ME. Students and practitioners in finance can benefit by the valuation results in the paper.Originality/valueNo previous studies have recognized the valuation issues resolved in the paper on the application of the popular and contemporary ME model of firm valuation to the MM valuation concepts. The new arguments in the paper are easy to understand and readily applied to firm valuation.

Optimal Debt and Profitability in the Trade‐Off Theory

ABSTRACTI develop a dynamic model of leverage with tax deductible interest and an endogenous cost of default. The interest rate includes a premium to compensate lenders for expected losses in default. A borrowing constraint is generated by lenders' unwillingness to lend an amount that would trigger immediate default. When the borrowing constraint is not binding, the trade‐off theory of debt holds: optimal debt equates the marginal interest tax shield and the marginal expected cost of default. Contrary to conventional interpretation, but consistent with empirical findings, increases in current or future profitability reduce the optimal leverage ratio when the trade‐off theory holds.

Does top managers’ experience affect firms’ capital structure?

Recently, the importance of traditional firm-specific determinants of capital structure has been challenged. The paper uses the trade-off theory to investigate the managerial experience of top managers as a determinant of capital structure. The paper applies system-generalized method of moments (GMM) which corrects endogeneity problem. Our results reveal that top managers’ experience is positively related to book value measures of capital structure. As top managers’ (CEOs) experience increases, both the book total debt and long-term debt ratios increase. Our results are robust using both the market total debt and long-term debt ratios. Based on the findings, the results suggest that top managers’ experience is a potential determinant of firms’ capital structure. The findings also suggest that experienced top managers maximize the benefits of debt interest tax-shield; top managers can increase firm value.

The Dynamics of Investment, Payout and Debt

We develop a dynamic agency model of a public corporation. Managers underinvest because of risk aversion. They smooth rents and payout. They do not exploit interest tax shields fully. The interactions of investment, debt, and payout decisions can change drastically depending on managers’ preferences. Managers with power utility set investment, debt, and payout proportional to the firm’s net worth, generating a constant (possibly negative) net debt ratio. With exponential utility, investment decisions are separated from decisions about debt and payout. More profitable firms become cash cows, and less profitable firms accumulate debt, as in a pecking-order model. Received July 9, 2015; editorial decision January 30, 2017 by Editor Itay Goldstein.

Tax Policy Assessment Challenges: The Case of the Slovenian Interest Tax Shield

Globalization affects national government fiscal policy; therefore, the recent policy debates focus on international fiscal competition. The national tax policies pay special attention to multinational companies, which are highly mobile and able to avoid taxes. The trend of tax rate cutting and tax base broadening (“the race to the bottom”) means that tax completion is one of the most important topics in the professional public. There are two main instruments to avoid the multinational companies' profit shifting; decreasing the corporate tax rates or the implementation of anti-avoidance rules. While tax policy implementation affects multiple stakeholders, a thorough, empirically tested and publicly aligned impact assessment procedure should be carried out. The main idea of this article is to analyze the procedure of impact assessment for tax policy in Slovenia, focusing mainly on the example of the interest tax shield, verifying the impact of the tax policy (thin capitalization rule) implemented in 2005 and offering recommendations for future tax policy. The results revealed that the Slovenian procedure for impact assessment concerning tax policy is used to fulfill formal compliance requirements. Such a declaratory and theoretical level of usage cannot contribute to effective results for tax policy. This turned out to be proved by the data from the financial reports of foreign companies operating in Slovenia for the tax policy instrument (thin capitalization). Contrary to expectations, the amount of debt to parent companies has on average increased, causing a capital to debt (to parent company) ratio considerably lower than the tax rules have restricted. The recommendations therefore are concentrated on a thorough quantitative and qualitative analysis of specific policy challenge. The globalization trend has affected tax policies all over the world, causing tax competition among countries. Multinational companies (MNCs) are very mobile and able to avoid taxes, so the tax code is one of the important factors in investment decisions. In this manner, the national tax policy can either decrease the corporate tax rates or implement anti-avoidance rules. The main article objectives are focused on a review of the existing procedure for tax policy evaluation, including the analysis of the impact of the thin capitalization rule on MNCs operating in Slovenia. The article finally provides recommendations for the tax instrument implementation of thin capitalization in general. The research methodology in based on a systematic literature review concerning the procedure for tax policy evaluation, while the second part employs statistical analysis including the Friedman test to evaluate the effectiveness of the thin capitalization rule and its impacts on foreign direct investment (FDI) in Slovenia. The research findings reveal a rather loose procedure considering the evaluation of the future impacts of tax policies, whereas the tax policy evaluation is addressed on the regulatory and declaratory level, while in practice it is often based on inertia, intuition, and incomplete recommendations from international organizations and supranational bodies. © 2017 Wiley Periodicals, Inc.

Tax Policy Assessment in Slovenia – Case of Interest Tax Shield

AbstractThe tax policy assessment is an indispensable strategy within any modern country’s system of governance. There are several types of “impact assessments”, with RIA as one of the most commonly used. This tool is used to measure and analyse the benefits, costs and effects of a new or existing legal regime, which can be carried out by collecting and analysing empirical data in the context of a broader decision-making framework. The main objective of the paper is to analyse which stage the Slovenian regulatory impact assessment is in, and whether this stage is sophisticated enough to provide for the essential verification of tax policy and specific instruments, focusing mainly on the case of interest tax shield issues. Methodologically, the paper is based on a systematic literature review, a survey for public consultations and statistical tools for calculating the differences in internal indebtedness in different observed periods. The results show that the Slovenian RIA is not sophisticated enough to evaluate complex tax instruments and policy. Nevertheless, tax policy decision-makers should reconsider the implementation of a thin capitalization rule (but also future tax policy instruments) focusing also on other, non-tax revenue, factors.

From interest tax shield to dividend tax shield: A corporate financing policy for equitable and sustainable wealth creation

This study critically analyzes debt-incentivized corporate tax and financing policy and provides an Islamic perspective to this important tax deductibility debate. This study advocates that the corporate tax incentive to debt (interest tax shield) be abolished and shifted to equity (dividend tax shield). Later, we use the implications of our proposed taxation policy to reframe the firm financing model and modify M & M's firm valuation model. We use a scenario-based simulation technique and conduct various policy experiments to assess the impact of conventional and proposed tax regimes on levered and zero-levered firms and their values. We find that aligning corporate financing policy with the fundamentals of Islamic finance helps restrain corporate indebtedness and promote profit and loss sharing. According to our proposed model, firms have a reduced cost of financing, tend to be more stable, and are value oriented, especially when they avoid debt to the maximum extent. We further propose that an optimal dividend payout ratio may lead to aggregate equilibrium amongst cost of financing, firm value, and corporate tax contribution to the economy. This study provides new contributions to the discipline of Islamic corporate finance.

Mortgage Interest Tax Shield and Home Mortgage Refinancing Decision

Under current low interest rates, the decision whether or not to refinance a mortgage is a timely and practically useful topic. However, the home mortgage refinancing decision is also affected by other variables such as personal tax rate. In addition, financial institutions provide different types of mortgage loans in terms of maturity (loan period), interest rate, processing cost, points (bank fee), and so forth. Several websites are available which can be used to aid making the refinancing decision. However, these websites programs are not explicitly geared towards selecting a low cost mortgage loan. Furthermore, these websites are limited in their usefulness due to inadequate assumptions or the difficulty of acquiring information required for the program. For example, a certain website requires information such as the expected future interest rate, the expected inflation rate, the standard deviation of mortgage interest rates, and so forth. To be practically useful, the assumptions should be simple and reasonably realistic. The objective of this paper is to prepare, under realistically reasonable assumptions, an Excel program which can select a low cost mortgage loan after consideration of the tax deductibility of mortgage interest rate. This paper can be used as a case problem for both undergraduate and MBA students. From the case, students learn how Excel (or any spread sheet program) can be programed and used to analyze finance problems.

THE RELATIONSHIP BETWEEN CAPITAL STRUCTURE AND CORPORATE TAXES FOR COMPANIES LISTED IN THE NAIROBI SECURITIES EXCHANGE

Purpose: The purpose of this study was to analyze the relationship between capital structure and corporate taxes for companies listed in the Nairobi securities exchangeMethodology: The study used descriptive survey research design. This study used Secondary data sourced from annual audited financial statement of the firms listed on Nairobi Securities Exchange. The population of the study consisted of companies listed on the NSE. Purposive sampling was used to select respondents from the sampling frame. A sample size of 46 listed companies for the year 2001 to 2011 were selected through random sampling. Data was analyzed using Statistical Packages for Social Sciences (SPSS) to derive descriptive results.Results: Finding indicated that the relationship between debt equity ratio and taxes profit ratio was negative and significant and that debtequityratio has a significant effect on taxesprofitratio.The findings pointed out that the existence of tax shield in a perfect capital market conditions cannot be reached, in an imperfect financial market, the capital structure changes will affect the company's value. The findings also pointed that firm which follows the trade-off theory sets a target debt to value ratio and then gradually moves towards the target. Accordingly, the findings agreed pointed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. Findings also pointed that a firm facing a low enough tax rates would also use equity, because investors pay more taxes on debt interest than on equity income. In conclusion, the findings pointed that the more profitable the firm the lower is the debt ratio.Unique contribution to theory, practice and policy: The study is recommended for commercial banks to issue corporate bonds as this would form a cheap source of finance and also the use of corporate bonds entails the enjoyment of the interest tax shield and consequently improving the shareholder’s wealth. The study also recommended that commercial banks should engage strategic investors. Further to that, the study recommended that the equity share holder should be substituted for debt shareholding in future, this is because an increase in debt shareholding arising out of substitution would be beneficial to the commercial bank because it will result into interest tax saving.