Page 206 - DCOM508_CORPORATE_TAX_PLANNING

Unit 9: Financial Management Decisions

investment opportunities. Flexibility is a powerful defence against financial distress and Notes
its consequences which may include bankruptcy.
3. Ensure that the Total Risk Exposure is Reasonable: While examining risk from the point
of view of the investor, a distinction is made between systematic risk (also referred to as
the market risk or non-diversifiable risk) and unsystematic risk (also referred to as the

non-market risk or diversifi able risk).
Business Risk refers to the variability of earnings before interest and taxes. It is infl uenced
by the following factors:
(a) Demand Variability: Other things being equal, the higher the variability of demand for

the products manufactured by the firm, the higher is its business risk.

(b) Price Variability: A firm which is exposed to a higher degree of volatility in the prices
of its products is, in general, characterised by a higher degree of business risk in
comparison with similar firms which are exposed to a lesser degree of volatility in

the prices of their products.
(c) Variability in Input Prices: When input prices are highly variable, business risk tends
to be high.
4. Subordinate Financial Policy to Corporate Strategy: Financial policy and corporate

strategy are often not integrated well. This may be because financial policy originates in
the capital market and corporate strategy in the product market.
5. Mitigate Potential Agency Costs: Due to separation of ownership and control in modern
corporations, agency problems arise. Shareholders scattered and dispersed as they are not
able to organise themselves effectively. Since agency costs are borne by shareholders and
the management, the financial strategy of a firm should seek to minimise these costs. One

way to minimise agency costs is to employ an external agent who specialises in low cost
monitoring. Such an agent may be a lending organisation like a commercial bank or a
term-lending institution.

Notes Agency cost refers to the cost incurred by a fi rm because of the problems associated
with the different interests of management and shareholder and the information asymmetry
that exists between the principal (shareholders) and the agent (management).
The agency cost of equity arises because of the difference in interests between the
shareholders and the management. Similarly the agency cost of debt arises because of
different interests of shareholders and debt-holders.

9.1.4 Capital Structure Decision and Tax Planning

Capital structure decisions are likely to affect companies’ tax payments, since corporate taxation
typically distinguishes between different sources of finance. Interest payments can generally

be deducted from taxable profits while such a deduction is not available in the case of equity
financing. Taxation of capital income at the shareholder level often differentiates between the

types of capital as well. Therefore, it can be expected that the relative tax benefi ts of different
sources of finance have an impact on fi nancing decisions.

In addition to above theory suggests that both corporate profit tax and personal capital income

taxes should be considered in order to analyse the tax consequences of capital structure choices

more accurately. Tax incentives for using a particular source of finance differ signifi cantly among
different countries. Given that interest payments and dividends are taxed differently at the
company level, this could lead to effective unequal treatment of debt and equity.

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