Why is interest as a tax shield so highly regarded?

[TheMotorcycleBoy]

Good afternoon everyone, and yes another of my general financial/company analysis questions. Apologies in advance if this post lands in the wrong topic/forum area.

As some of you already know we are fairly new here, and are interested in analysing companies, both from an investment and an interest point of view. The subject that's currently in my mind is using interest as a tax shield.

Now I understand all the maths, but what I don't really understand, is why it is argued as being potentially advantageous, particularly from a cash flow perspective. As usual I have been googling and youtubing, and as usual I seem to find copious amounts of HOW, but not so much of the WHY.

This is one such link:
https://www.youtube.com/watch?v=gxKcxR5p6EA&t=60s
(Note I deliberately set the start time 1 minute in since that's where the figures start to be mentioned.)

Anyway for anyone who does not wish to look at the clip, in summary the youtuber, basically outlines the difference in cash position between the levered and the unlevered firms.

=================Unlevered=================Levered
EBIT                  1000                    1000
Interest                 0                      80
--------------------------------------------------
Taxable income        1000                     920                  
Taxes (at 30%)         300                     276
--------------------------------------------------
Net income             700                     644
Cash flow from assets  700                     724

Interest tax shield = 24

Now whilst I understand that the levered firm pays less tax than the unlevered one, what I don't understand is why the levered firm can add the 80 pounds/dollars/etc. of interest back to it's net income, as a cash inflow, since surely this 80 must be handed over to the lender, presumably in cash?

Can anyone explain what is really meant when we say that the interest on the debt creates a more advantageous position regarding cash flow?

many thanks
Matt (and Mel)

[tjh290633]

Can't help you with this, Mel and Matt, but we have just celebrated our diamond wedding. I have spent a fair amount on the celebration dinner and on a party with neighbours and friends this afternoon, with much more on our forthcoming cruise.

I am consoled by the fact that I am cheating HMRC out of the 40% IHT that might eventually be due. Better to enjoy yourselves than to pay an insurance company to cover the liability, or even to deny yourselves and end up paying the tax.

TJH

[Dod101]

I must say that the commentator did not sound very sure of himself on the video, but he says in the clip that the cash flow from the assets is EBIT minus tax and if you do that well you certainly get his figures. He is not claiming that that is Free Cash Flow and I think that is the difference. He is treating interest due on the loan as a bit like the cost of dividends, just part of the cost of capital, and I think that explains it.

He is also illustrating that the most efficient capital structure is to finance the business with 100% debt!

All a bit heavy for a summer's Sunday evening but cash flow from assets is not the same thing as FCF in the business.

Dod

[TheMotorcycleBoy]

Umm.... yeah... thanks for trying guys.

Congrats on the diamond wedding TJH. Mel and I had our 20th "china" anniversary back in June, so we'll catch you up in no time at all

Matt

[Dod101]

I came across something similar later, and the answer is that as I said, cash flow from assets is before Interest or tax, but free cash flow is after these cash charges.

Dod

[TheMotorcycleBoy]

The reason, or at least the only one that I can think of, why this interest tax shield is seen as being advantageous, is due to the extra capital afforded to the firm. In the example I used in my OP:

=================Unlevered=================Levered
EBIT                  1000                    1000
Interest                 0                      80
--------------------------------------------------
Taxable income        1000                     920                  
Taxes (at 30%)         300                     276
--------------------------------------------------
Net income             700                     644
Cash flow from assets  700                     724

The interest is at 8%, and so the firm acquired 1000 extra capital too. However, as Dod remarked earlier this is cheaper, since had the equity route been used to acquire the capital then the firm would have been required to pay corp. tax on the dividends against the recently issued stock.

Which leads to my next query, and that is whether such a firm, can now ever to rid of this debt? And if it does wish to rid itself how can the principal be repaid - i.e. does repayment of principal escape corp. tax. too?

[SalvorHardin]

Why interest is often referred to as being a "tax shield" is because interest is a cost and costs reduce your taxable profits so you pay less tax.

The idea that debt is better than equity took hold in the 1950s when Modigliani and Miller came up with their Capital-Structure Irrelevance Proposition, which holds that in the absence of taxes whether a business is funded by debt or equity is irrelevant. Modigliani got the "Nobel" prize in economics partly for this. The idea of borrowing loads to leverage your return on equity became all the rage.

However the markets didn't listen to the great sage Yogi Berra, who said "In theory there is no difference between theory and practice. In practice there is". Economics is full of ideas which look good on paper yet turn out to be flawed in practice (macroeconomic foreasting is a good example).

The idea that you can load up businesses with massive amounts of debt and the effect is is just the same as if you used massive amounts of equity is really crazy, it's the Emperor's New Clothes. Unfortunately this has led to many companies being massively overborrowed. A major reason why we are seeing so many retail chains get into trouble is that many of them have been bought up by private equity specialists who loaded them with debt.

Sadly all too often the private equity people escape unscathed when the business collapses because the banks and bondholders have been far too lax with their lending criteria.

As to another of your questions, paying off debt is not an allowable expense for corporation tax purposes. The debt isn't a cost for tax purposes, but the interest is.

[TheMotorcycleBoy]

Thanks SalvorHardin,

Yes I did suspect that firms pursuing this option just loaded themselves with more and more debt over time, since it's only the interest part that's tax efficient.

The tax shield of £24 seems a bit immaterial as £80 of int. charge will still need to be settled - in cash presumably. Obviously it can reduce the cost of raising capital vs equity, but then again this form of capital imposes higher risk to the business in lean times, since the loan-type debt will have greater seniority to the equity.

[Dod101]

Why interest is often referred to as being a "tax shield" is because interest is a cost and costs reduce your taxable profits so you pay less tax.

With respect I do not think that answers the original question. There are plenty of expenses that will reduce your taxable profits so you pay less tax, but few of them are a 'good thing' The idea of a business is to increase the profits not reduce them.

The point at issue is cash flow from assets and free cash flow from the business. Taking on debt will, according to the commentator in the video, increase cash flow from the assets (but overall will reduce free cash flow from the business).

As a comment on loading firms with debt, you only need to look at the effect of more and more debt by looking at the results when firms are bought by private equity firms, often loading the bought film with excessive debt to raise the cash to do the buyout or to pay themselves a fat dividend. I think for most investors this sort of thing can be ignored.

Dod

[SalvorHardin]

With respect I do not think that answers the original question. There are plenty of expenses that will reduce your taxable profits so you pay less tax, but few of them are a 'good thing' The idea of a business is to increase the profits not reduce them.

It's all tied in with capital structure theory. Interest payments can be offset against your taxable profits but dividend payments cannot so debt is "cheaper". Hence the promotion of phrases such as "tax shield" to justify it. From the Harvard Business Review:

"Debt is a much cheaper form of financing than equity. It starts with the fact that equity is riskier than debt. Because a company typically has no legal obligation to pay dividends to common shareholders, those shareholders want a certain rate of return. Debt is much less risky for the investor because the firm is legally obligated to pay it."

https://hbr.org/2009/07/when-is-debt-good

Debt is "cheaper" to issue (because of the equity risk premium as above) but because Nobel prizes have been given for saying that debt financing is more efficient than equity this idea has taken root (especially amongst investment bankers who push companies to issue more debt). In theory the ideal structure for a company is the minimum possible equity (e.g. £1) with everything else being funded with debt (in this case debt is most definitely more risky because there is no equity to absorb the shock of a downturn in profits). This is highly flawed because the assumption that you can always borrow at market clearing interest rates is false - the theory takes no account of market failure.

[Dod101]

Thanks for that. I had not come across that before and I must say that theory is all very well for academics but in the real world......... But that is obviously where the idea came from in the youtube video. I really do not think it is helpful to the OP for him to be worrying about stuff like that.

Dod

[TheMotorcycleBoy]

Thanks for that. I had not come across that before and I must say that theory is all very well for academics but in the real world......... But that is obviously where the idea came from in the youtube video. I really do not think it is helpful to the OP for him to be worrying about stuff like that.

Dod

The debt re. cash flow thing, is complete nonsense as far as I can see, since what the poster says is that debt/interest/blah boosts cash from assets in fact he goes on to say, that in the levered case:

CFFA = 1000 - 276 = 724

but this is nonsense, since really the 80 interest will have to be paid for in cash, and so the real figure in 724 - 80. The debt most certainly did not increase ready cash, since presumably the firm needed the 1000 semi-urgently to buy machinery/ingredients/whatever so the extra cash (1000) has evaporated.

The only thing which is true is that what we all agree: the debt financing cost is less (than equity), though it's more risky (to the firm not a shareholder).

To be frank, I think this kind of detail is worthy of concern, we are apparently moving towards times of rising rates.....and the lesson (apparently) learnt from the 2007-2009, was that when one organisation keels over in times of a credit crunch, associated business tend to follow suit. I'm sure this is all the post - hasn't there been a huge number of LBOs, particularly over in the States?

Matt

[Dod101]

I agree with you but what I think you are missing is that in the youtube video he talks of cash flow from assets, not the free cash flow. There is a difference in that the cash flow from assets is before Interest and Tax. I agree that this is pointless as it is the free cash flow we are concerned about but we are talking here about academic theory. It is that subtle difference that I do not think any of us need worry about. Of course we want to be concerned about borrowings and the cost.

SalvorHardin seems to more up with this than I am but that is what I think the video is saying.

Dod

[TheMotorcycleBoy]

I agree with you but what I think you are missing is that in the youtube video he talks of cash flow from assets, not the free cash flow. There is a difference in that the cash flow from assets is before Interest and Tax. I agree that this is pointless as it is the free cash flow we are concerned about but we are talking here about academic theory. It is that subtle difference that I do not think any of us need worry about. Of course we want to be concerned about borrowings and the cost.

SalvorHardin seems to more up with this than I am but that is what I think the video is saying.

Dod

Yes, you're right - this video is more than likely aimed at economic students, rather than investors who are more focussed on useful cash.

thanks again,
Matt