Tax Consideration of Capital Structure

The cost of equity does not receive a tax break from the IRS.

A company goes through many considerations in choosing its capital structure, and one of those considerations is the tax impact. The two options for capital are debt and equity. One of them receives a tax break but increases the financial risk of a company while the other one does not share those same qualities.

Capital Structure

The definition of capital structure is how a company is financed. The two options for financing are equity and debt. Debt is just a contracted agreement that requires a borrower to pay interest on the debt at the specified dates. Equity is ownership shares in a company that give the owner the right to vote for company directors and gives them a claim on income. Capital structure can be all equity or a mix of equity and debt. It is usually discussed in debt-to-equity terms. Debt adds financial risk to a company because of the mandatory payments that have to be made. Equity capital, on the other hand, has no such payments.

Debt

The Internal Revenue Service (IRS) allows for the whole sum of the interest payments to be deducted on a company's income tax return, which means that a company's taxable income will be lowered if a company has interest expense. A lower taxable income means lower tax liability. The tax benefit can be calculated by multiplying the interest payments by the company's tax rate. For example, a company had $100 of interest payments during the tax year and the company's tax bracket is 40 percent. The tax benefit of the interest expense will just be $100 times 40 percent or $40. Equity receives no such favorable tax treatment from the IRS.

Impact

Because debt receives a tax break, the effective cost of debt is actually much lower than the stated interest rate, which makes debt a much more favorable source of capital. Companies view it favorably because a company can then significantly lower its cost of capital by taking on debt. The historical cost of equity for a company has been around the 10 percent range. If the interest on a loan is 10 percent, plus a company receives a tax break, debt becomes very favorable. However, using debt as a source of capital adds financial risk.

Focus

A company's priority is to balance the need for a lower cost of capital to improve shareholders' returns and the financial risk that comes along with debt. A company makes money by having a high spread between return on capital and cost of capital. Keeping return on capital constant, the lower the cost of capital, the better the spread and the bigger the returns for shareholders. Interest payments can be a big burden on a company and, if a downturn in the businesses occurs, the company could face financial distress. Equity brings no such risk, but its cost of capital is much higher, which is the dilemma that companies face.

References

• IRS; Deducting Business Expenses; June 2011
• The Motley Fool: Return on Invested Capital: Equity Isn't Free;