1. Introduction

Let us now investigate how taxes affect the previous discussion about the relevance of financing decisions. The key issue is that, at the corporate level, payments to debtholders and shareholders receive unequal tax treatment:

• Interest expenses are tax deductible and therefore lower the firm's pre-tax income
• Dividend payments, in contrast, are not tax deductible. They constitute a use of net income.

Tax considerations therefore favor debt financing. We can see this very easily. Suppose a firm operates at a tax rate of 35%. If the firm can replace 1 dollar of dividend payments with 1 dollar of interest payments to finance its activities, its tax bill will drop by 35 cents. Substituting equity with debt therefore lowers the firm's tax bill, which constitutes a source of value in addition to the value that results from the firm's operating activities.

To better understand the relevance of taxes for financing decisions, let us go back to the example from the previous section. For simplicity we ignore the individual scenarios (recession, normal, boom) and focus on the average expected values instead. Remember that the firm in question expected to generate an annual EBIT of 600, on average.

The only modification we make to the example is that we now assume that the firm is subject to a corporate tax rate of 35%. The immediate impact of this assumption is that the stock price of the fully equity financed firm drops by 35% from 10 to 6.5. To see this, remember that the value of the firm's equity corresponds to the following expression (in our simplified world):

Equity value = $$\frac{\text{Equity cash flow}}{\text{Cost of equity}}$$.

Without taxes, the annual payment to equity was 600, i.e., the firms full EBIT. Now that the firm is subject to taxes, the shareholders can no longer claim the full EBIT of the equity financed firm. Given a tax rate of 35%, the annual tax bill is 210 [= 600 × 0.35] so that the annual payment to equity drops to 390 [= 600 - 210].

 Expected EBIT 600 - Interest expenses 0.0 Earnings before taxes 600 - Taxes (35%) 210 Net income 390 Debt cash flow 0 Equity cash flow 390 Return to capital 12% Return to shareholders 12% Earnings per share 0.78

With an average expected return of 12% (unchanged), the value of the firm's equity drops from 5'000 to 3'250 due to taxes:

Equity value = $$\frac{\text{Equity cash flow}}{\text{Cost of equity}} = \frac{390}{0.12}$$ = 3'250.

Because the firm has no debt outstanding, this also corresponds to the overall value of the company. Put differently, the unlevered firm value (VU) is 3'250.

With 500 shares outstanding, the theoretical stock price is 6.5:

Stock price = $$\frac{\text{Equity value}}{\text{Number of shares}} = \frac{3'250}{500}$$ = 6.5.

Again, we find the same result when dividing the firm's EPS [= 390/500 = 0.78] by the cost of equity:

Stock price = $$\frac{\text{EPS}}{\text{Cost of equity}} = \frac{0.78}{0.12}$$ = 6.5.

Now let us investigate how debt financing affects the valuation of a firm that is subject to taxes.