#1 While calculating Cost of Capital, we use after-tax market value of Debt. However, for equity, we don’t use after-tax at all (i.e. we don’t multiply the market value of Equity with (1-t))? Why so? Is it that the companies don’t pay taxes on the funds raised through equity? I am curious.
#2- Reporting Equities on accounting statements: one of the things I have noticed is that equity goes in the “owner’s equity” section of the Balance sheet. Hence, it doesn’t get into the calculation of “taxable income.” However, this explanation merely answers a different question—how equity borrowing is reported on the accounting statements, not the reason why equity borrowings are not reported after-tax. Am I correct?
#3- Taxing funds through debt vs. equity: the act of borrowing funds through equity is not taxed. But, when we use that fund to earn money, the earnings are taxed. If the management decides to issue dividends from the earnings, then those come out of after-tax earnings. That means, the company has already paid the tax. This is a bit different from borrowing funds through debt because even if I don’t use these funds, I will have to pay (unlike equities) the interest , which is tax-free. However, when I use these debt-generated funds to earn money, the earnings will also be taxed, just as the case with equities. Am I correct?
Whereas interest on debt is tax deductable (and, therefore, reduces income taxes), dividends are not. Therefore, the company bears the entire cost of equity itself; there is no tax effect.
I believe that there is a fundamental misunderstanding here. Unlike money raised by issuing bonds, money raised by issuing stock is not borrowed (with the legal requirement to return it to the contributor at some future time). Money raised by issuing stock legally belongs to the company, because the owners sold a portion of the company to the stockholders. It is reported as equity rather than as a liability because there is no legal obligation to repay it. What it has in common with debt is that the money raised is not taxable because it is not considered income; it’s considered financing.
Once again, equity is not borrowed money; a portion of ownership is sold. When you receive (financing) money with a legal obligation to return it (i.e., you borrow it), the cost of that money is tax deductable. When you receive (financing) money without the legal obligation to return it (i.e., you sell a portion of the company as evidenced by stock certificates), the cost of that money is not tax deductable. It may seem inconsistent, but that’s the way that tax laws are designed.
You are correct that when you generate earnings – irrespective of the source of funds used to generate those earnings – the earnings are taxed.
Taxes on equity only matter on a shareholder level (e.g. personal income taxes on received dividends) and not on a company level. The reason why you consider taxes on the debt portion is that interests on debt are deductible from taxable income and therefore lower future tax burden on company level. This is the so called tax shield. As a consequence the higher the debt ratio on a company, the lower the capital costs and the higher the enerprise vaule (other else equal). This kind of leverage is often used by hedge funds when they leverage their investments in companies with a high debt portion.
Because interest and amoritization is tax deductible and reported as before cost of taxes, equity claims on the other hand are after-tax earnings, so we don’t deduct taxes twice. Dividends paid are not tax deductible either, for the same reason.
What kind of equity are you referring to? Minority Interest? Or IPOs and SEOs?
This question is a little confusing. But generally, interest paid on debt is considered an expense to the company which reduces taxable income. While on the other hand, there is no interest paid to equity holders, when you buy a share of the company, you are buying a proportion of the after-tax earnings that the company recieves, more or less. So there is no ‘expense’ here that reduces taxes. Consider equity as business owners of the company, and debt as third party investors who want to get their money back plus interest.
Hello S2000magician Greenman72 and others for correcting me. I am indeed wrong in using the word borrow. I will register this thing in my long-term memory.
I have a quick follow-up question on Mr.Smart’s post above:
Does it matter what kind of equity we are referring to?
Equity is not tax deductible, at all. Minority interest (proportion of non-controlling interest in a owned subsidry) is reported after taxes, and is not tax deductible.
IPOs and SEOs are equity financing of raising money, so they aren’t tax deductible either, neither are funds raised as debt reported on the income statement.
Rememebr that taxes apply to income and expenses, and not fundings. If I give my friend $5 to borrow, the government does not tax him. If I give a company $100,000,000 to borrow with no interest, the government has no claim on them. Only when I get or pay income (interest) are they tax deductible. Whether in the form of fixed outlays, or amoritzations (zero coupon bonds).
Thanks MrSmart and others for your inputs. I have another quick question on “Cost of Equity” — in many problems on the CFA exam, why is it that we calculate “Earnings Yield” to see the impact of raising debt on EPS. For instance, if Earnings yield = 5% and Debt is raised at 4.5% repurchase shares, EPS will increase. In this case, are we assuming that the cost of equity = Earnings yield? I am not too comfortable with these concepts, and hence I thought of asking this.
On the other hand, in many problems, we calculate cost of equity using CAPM. i.e. Kce = RFR + Beta (…).
Can someone please explain the difference and the logic behind these two scenarios?
The earnings yield is the total amount of earnings divided by the market cap, or in other words, the amount of EPS divided by the price of one stock. If you reduce the amount of floating shares by a cost of debt less than the earnings per price, then the amount of earnings available will be reduced, but by a smaller proportion compared the amount of shares repurchased, therefore your EPS increases.
Cost of equity is different and more subjective. The cost of equity is the minimum rate of return required for an equity investor. The cost of equity is an estimate for the total return to shareholders, as opposed to the cost of debt which is a fixed cost payed periodically. The reason for that is, you do not recieve all earnings in cash, some is reinvested into the business as part of company strategy, likewise, a part of your TRS is capital gains on shares, so earnings yield is not an always an accurate measure for TRS. The cost of debt and cost equity are both functions that include the RFR, depending on the borrower’s traits and the market conditions, make up the amount of return I need to give you my money.
The CAPM model is one method in estimating Ke, this is used by practioners worldwide and the most common form of calculating Ke, including the CFA curriculum, due primarily to it’s ease of use and practicality. However, the CAPM model is inheretly flawed, but this is another topic for discussion. For explainatory purposes, I’ll break down the real components of Ke using the more correct method, which the Arbitrage Pricing Theory (APT).
The rate of return that I require to invest my money in a share should be higher than the RFR that I could earn. So the first component is RFR. All the other components are risk premiums, which are basically compensations for inherit risk with higher returns. They may include liquidity, macroeconomic factors, size premiums, market-timing, business cycles, time horizons, inflation, temporary events which might include litigation, managment changes, turnarounds, capital structure changes, dividend policy changes and basically an infinite number of factors tailored for each company. However, for obvious reasons, this is much more difficult to calculate preciscley, so we rely on the CAPM instead.
I am still not clear. So does it mean that the cost of debt has nothing to do with Earnings Yield? I originally thought that if I use a higher interest-debt to repurchase shares, then overall my EPS will go down because I will have greater liability. On the other hand, if I use a lower interest-rate debt to repurchase shares, I will have less liabiilty => EPS will go up. I thought that this whole concept is very similar to evaluating investment strategies: If the cost of capital used to finance investment is less than the rate of return on the investment, overall investment will have positive NPV or earnings. On the other hand, if the cost of capital is greater than the rate of return on the investment, I will lose money.
In this regard, I thought Earnings Yield is as good as the cost of equity. CAn someone please clear up the confusion? Do you think that my brain is making wrong connections by applying investment strategies to EPS/Earnings Yield relationship?
Repurchasing shares does not create value, it maximizes shareholder value. The reason why EPS increases is because the earnings decrease from the additional interest expense, but less than the market value of a stock. So total earnings go down, but EPS goes up.
There is no NPV here since you are not investing money in anything. Repurchasing shares is a cheap and indirect method to pay your shareholders money, more or less. They are mostly used when either interest rates for debt are low, shares are undervalued, or management sees no better investment of money in projects that could provide a positive NPV. So when you think about it, it’s actually an adjustment to capital structure and a good sign that target capital structure is maintained without over-leveraging.
To get any confusion out of the way. Earnings yield and P/E ratios which are reciprocals, do not really mean anything. They are a relative measure, a financial indicator that investors commonly use for relative valuation of stocks compared to the market. The market capitalization is subject to human decision and forces of supply and demand, likewise, earnings are subject to manipulation and commonly goes through so. Cost of equity on the other hand, has to do with the minimum required rate of return for an investor with a share in x company, given their inherit risk components and potential for dividend payment, capital appreciation of shares, and net tangible value after all senior claims have been met.
Think of earnings yield as a benchmark for assessing performance and value. It’s the amount of earnings you are entitled to for every dollar paid in one stock. Although you don’t nessecairly directly earn that number on your investment, it’s just a tool for relative value, if that makes sense.
So to cut it short, if the amount of interest you pay on money you borrow is cheaper than the amount of earnings you get per share. Let’s say $5 interest on $100 debt vs $10 EPS on a stock with price $100, and we have 10 shares in circulation. So cost of debt is 5%, total earnings is $100, EPS is $10, and EY is 10%.
Then you are reducing total earnings by five dollars from interest, but removing one whole share from the pool of available shares on the market ($900 left), therefore you pay only $5 to acquire a $100 stock that earns $10, or 10%, so the numerator will decrease by the amount of interest, but the number of shares you divide the EPS on will also decrease by a bigger proportion, so you’re distributing available earnings on a smaller number of shares. Leaving you with an EPS of 95/900 = $10.55, and an earnings yield of 10.55%.
Now if you use a cost of debt higher than EY, let’s say interest of $15 on $100 debt, then the EPS will go down, because you’ve financed a purchasing of shares with a lot of money, driving your earnings down a lot more than the drop of market cap (price*number of shares) can compensate for.
Using the same EY as Kd will give you the same EPS.