Module 3.
0 Long-Term Financial Policy
To date we have examined the investment decisions facing a firm and in particular how we
evaluate long-term investments. Hopefully you are starting to understand that changes in one
area such as investment, also may mean changes on the financing side. In other words, many
decisions in corporate finance are interrelated.
In module 3.1, Chapter 13 introduces the financing of a firm’s investments and in particular
the use of debt. Module 3.2 (Chapter 14) reveals how dividend policy impacts significantly on
both the investment and financing within a firm.
31
Module 3.1 Leverage & Capital Structure
Chapter 13 examines the impact of leverage and capital structure on firm risk and return.
Leverage is a particularly important concept which will provide us with a theoretical foundation
upon which to make more concrete decisions on the best mix of debt and equity for a given
business. Then we will look deeper into the theoretical aspects of determining an optimal
capital structure in order to provide further insight into this complex topic.
Types of Capital
Note that the convertible instruments, capital notes and convertible notes do not fit neatly into
the category of debt or equity, and are sometimes called hybrid securities as they have features
of both debt and equity.
Basic Shortcoming of EBIT-EPS Analysis
EBIT-EPS analysis (Zutter textbook Section 13.3) concentrates on the relative effect of
alternative capital structures on earnings per share. In general, when the (pre-tax) return on
assets exceeds the interest cost of debt, the substitution of debt for equity will increase earnings
per share and when the cost of debt exceeds the return on assets, substituting debt for equity
will lower earnings per share. However, EBIT-EPS analysis fails to consider the implicit costs
of debt - particularly the increased risk of financial distress.
Capital Structure Theory – Personal Taxes
Our objective in examining the theory of capital structure is to determine the effect of financing
mix on the value of the firm. To do this, researchers have defined the value of the firm as
follows:
Value of firm = total assets
Value of firm = debt + equity
The development of the theory begins with perfect capital markets, concluding that capital
structure has no effect on a firm's value. However, when we look at the more realistic
circumstance of imperfect capital markets, then we can see that several factors may lead to a
preference for debt or equity financing. One of the factors mentioned in the textbook is taxes.
As the development of these theories was in the American context under a "classical" tax
system, it is necessary to refer to research of capital structure under a system of dividend
imputation.
Dividend Imputation Reading
You should take careful note of the following reading from Gitman, Juchau and Flanagan
(2011), Principles of Managerial Finance, 6th edition, Sydney: Pearson Education Australia,
p.594-95, about the Dividend Imputation System and its effect on capital structure. However,
it should be noted that the discussion concerns the Australian system and it uses a different set
of terminology compared to New Zealand. In New Zealand, we have imputed and unimputed
income, rather than franked and unfranked income as used in Australia. In addition, New
Zealand uses the term of imputation credits instead of franking credits as in Australia.
32
33
34
Effect of Corporate and Personal Taxes on Financial Leverage in New
Zealand
Taxes may have an impact on the optimal capital structure of the firm. A tax-optimal capital
structure is one that minimises the total government tax take. Below we look at the pre- and
post-imputation tax environments in New Zealand.
Pre-Imputation
Prior to the introduction of the system of dividend imputation (discussed in this Study Guide
in Module 1.1), a bias toward debt financing existed. This is because debt was taxed once only
in hands of the debtholder. In contrast, equity was taxed twice - once to the company, and again
to the shareholder when the earnings were distributed as dividends. Consequently, investors
preferred debt over equity financing of firms, as the use of debt minimised taxes and left more
earnings available to investors.
Post-Imputation
The imputation system ensures company income is only taxed once and therefore most
investors will have no tax-induced preference for debt or equity. However, when the dividend
payout is less than 100% of profit, those investors whose personal tax rate is lower than the
company tax rate and investors who are subject to capital gains tax14 will still experience a
weak preference for debt financing.
The rationale for the preference for debt is twofold. Firstly, a levered (indebted) company has
earnings subject to corporate tax (28% in New Zealand), so the government receives less, and
in the aggregate there is more money left for investors after paying taxes. Secondly, the higher
the retained earnings, the higher the share price appreciation and the higher the capital gains
earned by share traders. A levered company has lower earnings retained, so shareholders will
experience less share price appreciation, lower capital gains, and therefore lower taxes.
However, those investors whose personal tax rate is higher than the company tax rate but who
are not subject to capital gains taxes will have a tax preference to invest in a company with
100% equity finance and a zero percent dividend payout policy. Under this scenario the total
government tax take would be the corporate tax payable (28% in New Zealand).
Conclusion on Imputation and Capital Structure
For most individuals investing in New Zealand companies, tax does not affect capital structure.
For example, when payout ratios are less than 100%, low-tax rate individuals, and some
institutional or individual investors who are subject to capital gains tax may have a preference
for companies with higher leverage (debt). Foreign portfolio investors either have no
preference or a mild preference for debt financing. Finally, investors with tax rates higher than
the company tax rate will have a slight preference for equity. Therefore, it is difficult to say for
certain whether there is a tax-induced preference for debt or equity currently in New Zealand.
Note that taxes are only one factor affecting the determination of the optimal capital structure.
The other factors discussed in Chapter 13 including probability of bankruptcy, agency costs,
and asymmetric information, all apply equally well here in New Zealand. The point to be made
14
Institutional and individual investors who are in the business of buying and selling shares may be classified
as share traders, and would therefore be subject to tax on capital gains on the sale of shares.
35
is that there are several factors influencing the optimal capital structure, some favouring debt,
others favouring equity. The financial manager must attempt to find that ‘optimal’ balance
which maximises the value of the firm.
36
