Page 207 - DCOM508_CORPORATE_TAX_PLANNING

Corporate Tax Planning

Notes Therefore, we are interested in how flexible capital structure decisions are with respect to taxation,

given a bunch of non-tax determinants of capital structures. If companies’ capital structure

decisions are significantly restricted by non-tax factors, distortions of financial decisions due
to taxation may lead to inefficiencies in investment decisions and risk allocation. A higher tax

benefit of debt has the expected significant positive impact on companies’ fi nancial leverage.

Debt shares are positively affected by the level of dividend taxes and corporate profi t taxes,
whereas the taxation of personal interest income has only minor impact.
While suggesting a fundamental irrelevance of financial decisions for firm value, Modigliani and

Miller already refer to company taxation as a reason for preferring debt to equity. Within their

framework of perfect capital markets, the value of a permanently leveraged firm arises from
adding the corporate tax shield of debt to the value of an identical but unleveraged company.
Empirically, this proposition would imply a corner solution due to the tax shield which adds up
to the corporate tax rate times the market value of debt.
In 1977 Miller develops a broader perspective on tax incentives by explicitly integrating personal
income taxation into his model. He concludes that, under existing personal tax concessions made

to equity income, there is no optimum capital structure for any single firm. In contrast, De Angelo
and Masulis develop a theoretical explanation for the existence of a fi rm-specific optimal debt

to equity ratio by taking alternative ways to reduce the corporate tax burden (e.g. depreciation
allowances) into account. While a company’s effective marginal tax rate on interest deduction
depends on its non-debt tax shield substitutes and declines as leverage increases, the marginal
personal tax disadvantage of interest income stays constant. This leads to a unique interior
optimum, even in the absence of any non-fiscal incentives. There are several other studies also

on the impact of corporate taxation on financing decisions specifying the same preference of debt

to equity.
Self Assessment

Fill in the blanks:

1. …………………… is a composition of different types of financing employed by a fi rm to

acquire resources necessary for its operations and growth.

2. ………………. is classified as common stock, preferred stock, or retained earnings.
3. A company whose proportion of equity capitalisation is small is referred to as
……………….
4. …………………….. means taking advantage of equity share capital to borrowed funds on
reasonable basis.

5. ……………. on debt finance is a tax-deductible expense.
6. The agency cost of …………… arises because of the difference in interests between the
shareholders and the management.

9.2 Dividend Policy: Meaning and its Distribution

Dividend refers to the corporate net profits distributed among shareholders. Dividends can
be both preference dividends and equity dividends. Preference dividends are fi xed dividends
paid as a percentage every year to the preference shareholders if net earnings are positive. After

the payment of preference dividends, the remaining net profits are paid or retained or both
depending upon the decision taken by the management.
Dividends are usually distributed in the form of cash known as cash dividends or share called

share dividends. When a company distributes a cash dividend, it must have sufficient cash to

do so. This creates a cash flow issue. Profit generated may not be in the form of cash. You may

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