Saturday, February 6, 2010

Thoughts on Corporate Income Taxes and the Cost of Capital A Correction by F Modigliani & Merton Miller - Earl Malvar

In exploring the dynamics of leverage, taxation and ultimately the realized after-tax returns that a company reaps, the authors were quick to point-out that although it may seemingly be attractive to maximize the debt-issuance capacity of a firm, there are many real world circumstances to consider in formulating a capital structure policy. I am in agreement that beyond debt issuance as a predominant criterion to determining the cost of capital, a firm must assess its situation in its business environment. As noted in the article, limitations are imposed by creditors when issuing debt and that over-leveraging can sometimes put a company in a precarious position. Indeed, leverage can be a two-edged sword. It allows a firm to accelerate its business development and thereby its earnings potential, but it also exposes itself to over-commitment of cashflows to creditors who may stop at nothing to force bankruptcy in the event of a default. Furthermore, it was noted that an investment is never 100% debt-financed, in so much as opportunities to pay down debt or to issue equity to investors arise through the course of a business venture. I think this highlights the cyclical nature of markets when interest rates rise and fall, thereby allowing finance professionals of companies to adjust accordingly to varying economic scenarios. Taxes are already an unavoidable given to a going-concern, the tax perks realized by leveraging-up provides a firm an advanced foothold on capital-budget plans and may even boost returns, but care must be given in positioning one’s self when dealing with debt.

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