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Would a cut in corp tax rate be beneficial

Would a cut in corp tax rate be beneficial Doesn’t everyone want to keep what he/she has earned? It has always been somewhat tradition for Americans to work hard for their money, only to see some of it squandered away come tax time. Wouldn’t a tax cut, for some, be like a divine, heavenly grace? As the year 2001 unfolds and George W. Bush begins his presidency, income tax rates have, in fact, become a concern. President Bush is pushing for an income tax bill that will reduce the tax brackets from 15%, 28%, 31%, 36%, and 39.6% to a new bracket in 2006 of 10%, 15%, 25%, and 33%. A cut in individual income taxes would benefit most Americans and is well deserved. However, there is no plan to cut the corporate tax rates yet. A hypothetical decline to the corporate tax rates could spawn a number of possibilities for firms and/or even influence the market. However, will a decline in the corporate tax rate positively influence market volume and different firms’ financial activities (i.e. investing, repurchasing, options)? A question of this nature can be answered through analysis of the benefits or detriments obtained by two companies due to the reduction. There is a basic relationship between the market volume and corporate tax rates. A decrease in the corporate rates would allow companies to pay less on their earnings, leaving them with more Net Income (NI). With this increase in net income, a company can afford to invest in other areas or it allows them to repurchase their stock. By repurchasing stock, the market volume drops by the amount of stock that has been bought back. In addition, buying back shares can affect the overall outcome of the market that day depending on the company engaging in the repurchase. A company with a large stake in the market who buys back a considerable amount of stock will cause a greater fluctuation in the volume. In buying shares, the overall value of the market will rise due to the price increases that occur. If the opposite occurs, the tax rate is increased; some firms may have different decisions to make. Because an increase in the tax rate affects a company’s net income in a negative manner, funds for operations and other activities will become diminished. With the net income being less significant, a firm may need to participate in a form of either debt or equity financing to obtain funds needed to operate. Upon reviewing these companies who use financing in their operations, an analyst may view this company as a candidate for increased riskiness. If the risk is too great and a feeling of uneasiness sets in on Wall Street, investors may begin to sell that firm’s stock, dropping the market price per share and possibly the value of the firm itself. The reasoning? Simple: if the price of the share decreases, then there is a possibility that when the time came for a favorable risk adjustment, investors would be paying a lower price per share than the firm is really worth. The amount of equity that they would receive from their outstanding shares would decrease. Also, if the tax rates rise and the company has been deemed riskier than before, some insiders may begin to sell their shares of the firm. When this hits the market, it sends a negative signal to investors to sell, which will dump excessive shares onto the market. Conversely, if the degree of risk is not in excessive measures, investors might purchase more shares in hopes that the increased risk will yield a higher rate of return; a classic example of the risk-return trade-off. Along with market performance, a firm may need to adapt its financial activities as well. These activities all relate to the way the firm is organized, in particular, its capital structure. Included in capital structure is the aspect of convertible bonds. These bonds can be converted to a specified amount of common stock. The downside of these convertible stocks and bonds is that they have the potential of diluting the Earnings Per Share (EPS) because a shareholder’s share of ownership could be reduced through the exercising of the conversion option. This will then increase the amount of common shares outstanding, which is a deciding factor in the equation of the EPS. A simple example can be done giving the following information: The EPS for this particular stock has dropped $6.67 per share. By converting stocks and bonds to common shares, the shareholders are diluting their own earnings. There are several options a company can take in its everyday operations that involve and make up the basis for capital structuring. A firm can repurchase their stock from the market and finance themselves either with debt or equity: this decision depends on outside stimuli such as a tax rate. The first policy that a company can employ is that of a stock repurchase. Stock repurchases can be either discretionary, informational, to please “The Street”, or possibly a combination of some or all. If the company has excess cash on hand they may, at their discretion, buy back shares on the open market or by way of a tender offer (offering to buy back shares from shareholders at a certain price). Also, a stock repurchase may be along the lines of being an informational action. In purchasing their stock back a company sends a positive signal to investors that it believes its future will be prosperous. Lastly, and linked to being an informational action, is keeping analysts on Wall Street “happy”. In this case, any repurchasing of stock gives an analyst a feel for how the company thinks they are financially. Because of this they (analysts) can issue “buy” recommendations to investors. Now to show how a reduction in corporate taxes would affect a company’s decision to repurchase. “One of the chief reasons corporations choose stock buybacks over cash payouts to reward investors is taxes” (Lazo, WSJ 3/12/01). To get an idea of what the corporate tax rates look like, look at the actual tax table (Figure 1). Source: Needles, Anderson, and Caldwell, 1996. Stock repurchases, unlike dividends, are taxed at the capital-gains rate, which generally does not exceed 20%. However, dividends are taxed at ordinary rates and as the table demonstrates, can reach high percentages. The companies that would take this approach would most likely be of a larger genre than other companies. Smaller businesses “are generally organized so that they pass taxable income on to their owners, effectively paying tax at the individual rather than the corporate rate…” (Martin, Dow Jones 3/8/01). If the corporate rate were to rise, larger companies would be inclined to attempt a stock repurchase based on the underlying theme that they save money by being taxed at the capital-gains rate and not the ordinary rate. Then again if the rate was declined, larger firms might look towards issuing dividends because it may lose money if the capital-gains rate is higher than the ordinary rate. Plus, the amount of taxable income decreases with the payment of dividends. However, as stated earlier, smaller businesses may not have the stability to repurchase its stock and rely on dividend payments. The size of the company usually dictates whether to buyback stock or not. Another decision a firm must make is how to finance the company. There are two possible options that they can take: debt or equity. The first of these two options is the most enticing for a Chief Financial Officer (CFO). Debt financing is considered a lower risk security that is based on a fixed contract. The future value of debt financing is fixed and is specified. A decrease in the corporate tax rate may not benefit this form of financing. A CFO is pleased by an increase in the corporate tax rate. This highly important position in a corporation wants to keep as much debt as can possibly be sustained. According to Modigliani and Miller, the fathers of the Capital Structure Theory, in a perfect world, a leveraged firm would desire to keep the interest on the debt as high as possible because it will increase the corporation’s tax shelter. Subsequently, a firm’s value will also increase if the tax shelter is elevated. This can be determined by simply evaluating the value equation for a leveraged firm: So by increasing the tax rate and keeping the interest from debt high, a firm drastically augments its own value. In this case, debt financing is the optimum choice whether the tax rate goes up or down; however, if a CFO had his wish, the rate would go up to benefit the company’s worth. The least preferred way to raise capital is through equity financing. It is the last option for financing according to the Pecking Order Theory. The theory states that the order, in which a company will attempt to raise capital, begins with internal liquidity and advances through stages after each of the previous stages has been exhausted, till it reaches equity financing. The reason that equity financing is so disliked among CFOs is because there is not definiteness on the future value of this capital raising method. Because there is no specified future value, it is based on a residual claim contract. This means that it will be paid after all other costs have been accounted for. Because costs can vary from period to period, a set value cannot be established. Equity financing is usually achieved through the issuance of stock to the general public or through private placement. Some companies may look to private investors to buy up shares of stock, while some may choose the route of selling to the public. An example of equity financing in today’s market can be seen in IntelliCorp Inc. (INAI). This particular company bases its capital structure in the previously mentioned complex structure. It recently “raised $5 million in equity financing through the sale of 8% convertible preferred stock” (Kim, Dow Jones 3/12/01) to corporate investors. In either form of capital structure, debt & equity financing can be accomplished. Critical analysis is the next step in evaluating the benefits or disadvantages of a cut in the corporate tax rate. By looking at two different companies, a better understanding can be achieved. These two companies are different in nature: Merck Pharmaceuticals relies on a “first-mover” principle, while Ford Motor Co. is cyclical in nature. Examining the effects of a tax cut on these two companies will attempt to demonstrate the benefits or detriments imposed due to this hypothetical cut. Before delving into the benefits or drawbacks of a corporate tax cut, let us look at the companies’ backgrounds. Founded in 1903 by Henry Ford, Ford Motor Company has had a very lucrative history. It has taken up many different facets of business, including the financial services sector and even electronics. Currently, Ford is the largest producer/seller of trucks and the second largest manufacturer/seller of cars. Rated second on the Fortune 500 list of the largest industrial companies, Ford recorded $142.6 billion in sales and revenues and a net income figure of $6.5 billion in 1998. It has also spun off wholly owned subsidiary, Visteon to expand its market for automotive components worldwide. Also a leader in its field of pharmaceuticals, Merck & Co. has done well by way of their research & development program. It is the leader in manufacturing human and animal health care products. Some of its more important products are Vasotec (inhibitor for high blood pressure), Zocor (cholesterol-lowering agent), and Crixivan (for treatment of HIV/AIDS). Merck & Co. netted $6.82 billion in income for 1999, an increase of approximately $1 billion. However, these two companies differ in as many aspects as they do compare. First, Ford Motor Company is based in a consumer demand industry. If the demand for automobiles, etc., they will have to cut production, thus cutting into sales and revenue. Merck & Co., on the other hand, has more predictability as far as sales. Pharmaceuticals are, for the most part, necessary in peoples’ lives. Due to this feature, Merck & Co. is a more defensive company and stock. Because people need medicine, the demand will never go down, leaving stock prices at consistent rate. Ford, however, based in production and demand, tends to be a more cyclical stock. It will fluctuate with the economy. When times are more rigorous, people will not be as apt to buy a car or truck. It is important to look at the backgrounds of the companies’ to see exactly what sort of effect this hypothetical cut would have. To start with, both of these firms are leveraged firms, taking on equity and debt financing. Being that the firms are leveraged, a movement in the corporate tax rate will change the beta, or riskiness of the company. One way to look at that is to look at the formula for finding the beta for a leveraged firm. Bj = beta for a leveraged firm Bju = beta of an unleveraged firm B/S = debt-to-equity ratio in market value terms By decreasing the corporate tax rate (Tc), the number value of the right side of the equation will go up, causing the beta for the leveraged firm (Bj), to increase slightly, all things remaining constant. Companies may frown upon this out of their reputation to investors. It usually isn’t in the best interest of a company to let their beta get a great deal higher than the market value of 1. In this case, it would be detrimental for any fluctuation in the corporate tax rate. Another detrimental aspect of a corporate tax cut would affect the After-tax Cost of Debt. With a decrease in the marginal tax rate, which includes both federal and state taxes, the after-tax cost would increase because it is a function of the tax rate multiplied by the before-tax cost of debt. The formula is shown as follows: Another way to demonstrate the increase in the after-tax cost of debt is by presenting a visual aid in the form of a table. • 2.68% is Ford Motor Company’s Ki (currently have a 33% corporate tax rate) • 2.78% is Merck & Co.’s Ki (currently have a 30.5% corporate tax rate) As seen in the table, if the marginal tax rate goes down then both companies’ Ki would increase incrementally. This would hurt a company who is rooted in debt financing because it would increase the rate at which they borrow. The last disadvantage of a corporate tax cut would be for those companies that seek a high tax shield. With a higher tax rate, a corporation can take advantage of their high debt financing. The interest paid on the debt is a tax-deductible expense. The more interest paid on debt reduces the before tax income. This lowered figure will be taxed at the same rate as a company with less or no debt financing. The result: the higher debt-financing firm will have more money available to all of its security holders. Why is this? Because the income available to all security holders is the interest on debt (also known as income to debt holders) plus the income available to common shareholders (the income after taxes are taken out), the more interest you can deduct, the more your security holders will get. This can be shown between Ford Motor and Merck & Co. in the following: As seen above, Merck & Co. has a greater income available to their security holders. This is due to the bigger quantity of debt. Merck & Co. relies strongly on debt to finance their extensive Research & Development program. Ford Motor Company does not have the same amount of R&D due to the particular industry that they are in. Merck & Co. would not favor a corporate tax cut because the shield that they would lose is vast. Ford Motor may be indifferent on this, despite the fact that they finance with 74% of debt. However, the amount of debt is in no comparison to that of Merck & Co. $ 5,352,100.00 35% $ 1,632,215.00 $ 5,393,270.00 34.5% $ 1,644,770.50 $ 5,434,440.00 34.0% $ 1,657,326.00 $ 5,475,610.00 33.5% $ 1,669,881.50 $ 5,516,780.00 33.0% $ 1,682,437.00 $ 5,557,950.00 32.5% $ 1,694,992.50 $ 5,599,120.00 32.0% $ 1,707,548.00 $ 5,640,290.00 31.5% $ 1,720,103.50 $ 5,681,460.00 31.0% $ 1,732,659.00 $ 5,722,630.00 30.5% $ 1,745,214.50 $ 5,763,800.00 30.0% $ 1,757,770.00 $ 5,804,970.00 29.5% $ 1,770,325.50 $ 5,846,140.00 29.0% $ 1,782,881.00 $ 5,887,310.00 28.5% $ 1,795,436.50 $ 5,928,480.00 28.0% $ 1,807,992.00 $ 5,969,650.00 27.5% $ 1,820,547.50 $ 6,010,820.00 27.0% $ 1,833,103.00 $ 6,051,990.00 26.5% $ 1,845,658.50 $ 6,093,160.00 26.0% $ 1,858,214.00 $ 6,134,330.00 25.5% $ 1,870,769.50 $ 6,175,500.00 25.0% $ 1,883,325.00 $ 6,216,670.00 24.5% $ 1,895,880.50 $ 6,257,840.00 24.0% $ 1,908,436.00 * Ford's NI was $8,234,000 in 2000. *Merck's NI was $2,511,100 in 2000. On a lighter note, there are three scenarios in which a corporate cut may prove lucrative for the companies. The first of these is the firms’ cash flows. Because a corporation’s cash flows are based on after-tax net income plus non-cash expenses, a lower corporate tax rate would increase the company’s cash flows. The lower the rate, the higher the after-tax net income. One way to look at it is to compare Ford Motor Co. and Merck & Co. The following demonstrates the advantage of lowering the corporate tax rate: The cash flow is determined by calculating EBIT – (EBIT * tax rate). The chart on the previous page shows that the cash flow for each company goes up, all be it at a slow pace. Ford’s starting Net Income as noted was $8,234,000 and at its current tax rate (33%), sits with $5,516,780 as its cash flow. Merck & Co. has its current corporate rate at 30.5% and with a Net Income of $2,511,100; has a cash flow figure of $1,745,214.50. By increasing their after-tax NI, it also helps boost the Return on Equity (ROE). Stockholders like to see a positive ROE. This ratio measures the earning power on shareholders’ book-value investment. As mentioned before, a decrease of the tax rate, the after-tax net income will rise as well as the net profit margin (NPM), a component of the return on equity. A high return on equity usually reflects a company’s approval of strong investment opportunities and effective management. Ford Motor has a high ROE at 25%, while Merck & Co. has a return on equity of 49.5%. Merck & Co.’s exceptionally high ROE shows that they are confident in their investments in the pharmaceutical industry. The computation of this can be shown below: Merck & Co.’s high return on equity could, along with confidence in investments, be due to the amount of investments that Merck has taken on. Due to its large R&D department, it is more likely to invest and be invested in. Ford Motor Company is not as inclined to make such R&D developments due to the automotive industry that they are part of. So the decrease in the taxes could boost the return on equity and possibly send signals to brokerage houses and/or individual investors about their confidence in the future of their business. The last benefit for a corporate tax cut is the influence it has on the Weighted Average Cost of Capital (WACC) of a firm. The reason for worrying about the WACC is that by calculating the weighted average cost and accepting projects with a higher yield than the company’s WACC, the company can effectively increase its market price of its stock. In our case, Ford Motors and Merck Pharmaceuticals are somewhat similar in their beta or risk feature; however, the ratio of debt to equity financing differs greatly. Ford relies on 74% of debt financing, while Merck only delves in 19% of debt. Fittingly, Merck’s WACC is greater than that of Ford’s because of this differing capital structure. Working Cost of Capital - Ford Motor Co. Cost of Debt % Debt (D/E) Cost of Equity % Equity WACC Cost of Debt % Debt (D/E) Cost of Equity % Equity WACC Because Merck’s and Ford’s beta figure are so close to the market average of 1, their cost of equity is equal to or greater than the market average. With a higher equity financing strategy, Merck is able to increase its WACC. The ability to maintain a larger weighted average cost of capital will enable a company to accept higher yielding projects, which in turn will increase its stock price. For most of us a tax cut would be something much appreciated. However, in the corporate world such a tax cut might be frowned upon. Taking the information presented earlier, there are both pros and cons to this issue. On the one hand, it would increase cash flows, return on equity and weighted average cost of capital, which can improve the company’s financial stability and/or impression upon investors; there is also the issue of the tax cut increasing beta, the after-tax cost of debt and the decreasing of the tax shelter. These issues seem to equal themselves out and whether or not it is beneficial depends on the company in which the tax cut will be implemented on. For Ford Motor Company, a tax cut might work to their favor. By decreasing the rate, Ford’s return on equity will increase. However, Merck & Co. may hope for a veto of that tax cut. With a cut they would be increasing their cost of debt, in which they have excess financing ($161 billion). They would also lose out on their tax shield from the interest on their debt. Overall, the economy, the market, and the individual sectors seem to be doing well. To tamper with things now would almost certainly throw a wrench into what the Fed has already done to try and stimulate the economy. To follow in the old proverb, “If it isn’t broke then don’t try to fix it.” Benefits and detriments are, in this scenario, purely reliant on the company and its type of business. Bibliography: Bibliography Kim, Yun-Hee. “IntelliCorp Raises $5M In Equity Financing.” Wall Street Journal Interactive.(March 12, 2001). Lazo, Shirley A. “Bush’s Tax Plan: Dividend Booster.” Wall Street Journal Interactive.(March 12, 2001). Needles, Anderson, and Caldwell. Principles of Accounting. Princeton, NJ: Houghton Mifflin, 1996 (p.1162).

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