Debt Is Not Cheaper Than Equity
One of the most important questions for students of corporate finance has to do with whether value can be created on the right-hand side of the balance sheet. Earlier I pointed out why value cannot be created from cash dividend payments, share buybacks and even from splitting the shares. It is time now to take on the most important question of all: Why debt is not cheaper than equity.
The best way to see the development of thinking amongst serious researchers in finance begins with the position that academic scholars took prior to 1958. The year 1958 is critical because it is the year in which Franco Modigliani of MIT and Merton H. Miller of the University of Chicago published their path-breaking paper that applied the concepts taught in microeconomics to the discipline called finance. Therefore, 1958 is viewed as the beginning of Modern Finance. Before their work, debt was considered to be cheaper than equity for an unusual reason, an assumption that the financial markets were dominated by investors who were financially unsophisticated. This dominant view was expressed by three professors of the Harvard Business School, Pearson Hunt, Charles Williams and Gordon Donaldson. Their textbook, “Basic Business Finance,” was all the rage, and in that volume they claimed that as a firm’s ratio of debt-to-equity increases, the cost of equity capital does not increase at all. Thus, as debt enters the capital structure, the ratio of debt-to-equity increases, but according to them the cost of equity capital does not increase despite the fact that shareholders are bearing additional risk in the form of fixed interest payments that have to be paid before shareholders receive their rewards. In their view the weighted average cost of debt and equity capital (WACC) falls, and with the decline in the cost of capital, the value of the firm and its shares increases, given the simple basic valuation model as follows:
Notice that if the denominator falls and the numerator remains unchanged, the value must increase. Please also keep in mind that the net operating profit (NOP) is unaffected by interest expense since NOP is profits before financing charges.
The question should be, why did Hunt, Williams and Donaldson assume that the cost of equity capital would fail to increase with the debt ratio since shareholders clearly were bearing much higher risk than in the debt-free case. Their answer was that investors were simply too unsophisticated to recognize the new risk that was created from debt financing. The Harvard professors did not say that shareholders would fail to recognize the risk indefinitely, but rather immediately they would fail to recognize it, so that firms increasing their debt ratio would create value by essentially fooling the investors into believing that the cost of capital declined, when in the world of sophisticated investors that of course would not have happened.
The mistake made by Hunt, Williams and Donaldson is a most fundamental one. In microeconomics, we are taught that prices are formed at the margin by the smartest players in the game. The Harvard team made the assumption that all players matter, and thus the weighted average of all the players, most of whom are ignorant of market behavior, led them to the conclusion that markets were too unsophisticated to appreciate the increase in financial risk created when debt is introduced into the capital structure.
Modigliani and Miller (MM) cleared that up with their 1958 paper on cost of capital, in which they show in Proposition 2 that the cost of equity capital is a rising function of the debt ratio, so that as soon as the debt ratio starts to increase, the cost of equity capital increases at the same time, and this perfectly offsets the lower cost of debt, resulting in no change in the WACC. Incidentally, their arbitrage proof was a dramatic innovation in the theory of finance. No one had ever thought to prove the point the way they did.
However, when MM introduced corporate income taxes into their analysis, they showed that the value of the firm increases as the WACC declines from tax deductibility of interest expense. They showed that the present value of the expected future tax savings from debt is equal to the statutory corporate income tax rate multiplied by the amount of debt, tD. Notice that for every one dollar of debt, the value of the shares would go up by the tax rate times that dollar, or in the U.S. at about 40¢. So, the MM position is different from the Hunt, Williams and Donaldson position by the fact that MM assumed that markets are highly sophisticated and yet there is a tax benefit to debt financing. This is the way corporate finance has been taught in virtually all undergraduate and graduate business schools all over the world for more than 50 years.
The instructors in finance appear to have completely forgotten the important presidential address made by Merton Miller to the American Finance Association in December, 1976. His paper is called “Debt and Taxes,” and it was published in the May issue of the Journal of Finance in 1977, also known as the Proceedings Issue, because it presents the proceedings papers presented at the annual American Finance Association program. Merton Miller was the President of that organization in 1976.
Miller asks a brilliant question in his speech: Why do firms voluntarily pay corporate income taxes if they can reduce such taxes or even eliminate them with the stroke of a pen. Borrow sufficient sums, and the tax benefits of debt financing could and should ultimately offset all taxes on operating income, known as EBIT, Earnings Before Interest and Taxes. In fact, rather than there being an optimal debt ratio, there should be an optimal amount of debt so that given the interest expense and the tax rate firms should borrow enough money so that interest payments completely tax shelter operating income. Thus, value is maximized with zero taxable bottom-line profits, and thus the best earnings per share figure, is no earnings per share at all! Isn’t that a delicious conclusion?
In Miller’s paper he takes us on a journey by providing popular explanations that limit the ratio of debt-to-equity so that the tax deductions for EBIT supposedly are not possible. However, he refutes each one of the explanations, ultimately suggesting that firms could issue high yield bonds as the risks of borrowing increase. He even pointed out that in the late 1880s, during the bankruptcy of the transcontinental railroads, the court created a new instrument called “Income Bonds” that only pay interest if the firm has sufficient income to do so. In the event firms would become delinquent, the interest expense would be put into an arrearage account, and if the delinquency continued long enough, for say 3 or 4 years, ultimately the debt would convert automatically to equity, thereby eliminating the bankruptcy issue. In more recent times, so-called high yield bonds, also known as “Junk Bonds,” have been able to do the very same thing. So, in conclusion, operating income of firms could be tax sheltered with interest expense as firms would have fairly high ratios of debt-to-equity.
In that same paper, Miller presents a tax shield formula that determines when and if debt is cheaper than equity. The gains from leverage would be equal to the following formula:
tc is the statutory corporate income tax rate. tps is the income tax rate paid by investors who own shares and, of course, their tax rate is the tax on cash dividends received as well as the tax on capital gains. In the denominator, tpb, is the tax paid by investors buying the debt of the firm.
In the real world, we should expect that the corporate income tax rate is very close to the tax rate for investors who receive interest income when they purchase the debt. Thus, in the fraction those two expressions should cancel out, and thus the tax benefit of debt financing must come down to tps, the tax rate paid by investors who own the shares. The tax on dividends historically has run at a much lower rate than the tax on ordinary income for investors. In addition, the capital gains tax does not get paid at all unless investors voluntarily decide to sell shares. If they follow a buy-and-hold policy, the capital gains tax is deferred indefinitely, and perhaps forever in the U.S. where the tax basis for heirs is the price of the shares on the date of death, and so heirs pay none of capital gains tax that has accumulated. Furthermore, investors can use the margin in their brokerage account to tax shelter the dividends quite easily, so the tps is very, very close to zero, if not zero itself, and thus the tax benefits of debt financing virtually disappear.
It has always been my opinion that students of corporate finance should be required to read Miller’s “Debt and Taxes” paper, because it has such a dramatic impact on corporate policy.
In contrast to the presentation made by Merton Miller in that paper, I prefer to think about the issue a little bit more simplistically. If the world consists of borrowers, lenders (shareholders are merely junior lenders) and the government, then if interest expense is tax deductible to the borrower, the question must be: Who is paying the tax? The answer must be: The lender. After all the borrowers are getting the tax deduction. What would lenders do if they realize that they are paying the tax? The answer is, they would gross up the interest charge pre-tax so that the post-tax cost of borrowing would equal the pre-tax cost of borrowing, had the interest expense never been tax deductible in the first place.
There are interesting tests to substantiate this. Since 1976, when I was invited to South Africa for the first time, I have had the pleasure of being a visiting professor at both the University of Cape Town and the University of the Witswatersrand. I have become familiar with the methods of finance in that country where the capital markets had not been well developed. Firms used preferred stock quite actively as a substitute for debt. Interestingly, the banks purchased the preferred stock from companies or alternatively made them loans. The after-tax cost to the bank was exactly the same for both. Actually it was slightly higher for the preferred stock, because preferred stock is junior in the event of bankruptcy.
However, adjusted for that, the two cost exactly the same, as the new theory would predict. What does that mean? It means that debt is not cheaper than equity after all. It is the same as the treatment in the original paper by MM in 1958, but for what they refer to as the no-tax case. That is, the tax benefits of debt financing do not exist. Although debt is cheaper than equity, that is only in the sense that the borrowers get paid first before the shareholders. This means that the cost of equity capital rises to offset the lower cost of debt and the impact on value is zero.