## Wednesday, May 18, 2011

### The Tax benefits~

Is tax good? Well, it fully depends on the policy written in the law. Whenever we say tax, normally and casually, it doesn’t give much good sense, as it means a “payment”.

Entertainment tax, government tax, service tax... wow! the bills... However, a good citizen may choose to say : I love tax! Ya right, go for it dude! So how tax impact our living? Some expenses are tax deductible, and for that reason, be smart in filling up the form! When I was in the course of principle of Malaysian Taxation in UUM, I was taught of how to compute the tax payable. That’s interesting.

Now, putting it into the field of finance, in finance, we emphasize on tax too because tax benefits give rises to the NPV of a project. Assuming a 5-years project was valuated its NPV of (1000) if full equity financing is used. This project should be rejected, a rational financial analyst may say.
However, would changes happen if partial of the financing were sourced from loan?

To account that:
Suppose a company decided to borrow RM30000 at 10% interest rate to be part of the financing sources. Here, the NPV of the loan would be:

NPV of loan=Loan received-(PV of taxed interest payment)- PV of loan
Thus,
NPV of loan=RM30000-RM1980 {(1-1/((1+0.1)^5))(1/0.1) }- (RM30 000)/((1.1)^5)
NPV=RM3866.61
This NPV value reflects the tax benefits on interest paid.
To prove that: in the event of no tax,
NPV of loan=RM30000-RM3000 {(1-1/((1+0.1)^5))(1/0.1) }- (RM30 000)/((1.1)^5)
NPV=0.

Note: Assuming no floatation cost, tax rate is 34%
In time value of money, whatever received in future is always valued at lower than whatever received today. The RM30 000 received today can be highly beneficial to the borrower, because he/she can use the money now for profitable investment income and repay the money in full later. However, the lender NOT STUPID too, they charged interest on the loan received. Thus, the interest paid inclusive of the element of “discounting factor and risks”, the risks refer to the uncertainty of repayment on borrower or some unforeseen events in future. Thus, The RM30000 received is positive and the remaining two items are negative.

So, why the final summation is in positive? Refer first equation. That’s because of the tax deductibility on interest payment.

Remember EBIT? Tax payment is calculated after deduction of interest payment. If no interest, means higher EBT, which means more tax. If interest exists, means lower EBIT, and lower tax. Huh... lower EBT? does that means my position as equity holder receives lesser??

The different of the two is the tax benefit of interest. So eventually, the NPV of loan becomes positive.

haha... when a firm raise funds through debt financing, the residual net profit, will be distributed to FEWER equity holders. On the contrary, when a firm raise funds through equity financing, for example, issuing common stocks, the residual net profit, will be distributed to more equity holders. so, bigger pie but more slices VS smaller pie but lesser slice.

You see, the loan borrowed must be repaid, through interest and principal in full. However, when both were fully paid, the NPV of loan should equal to zero, but why residual positive? That’s because tax exemption happens on every interest payment we made.
So, is debt financing good? That depends on our risk attitude. Debt increases firm’s value through tax benefits but decreases in value through bankruptcy.where the scale lies? hump...