So Microsoft is going to raise money on the debt markets to buy back their stock, which they consider underpriced. This is a popular move when debt is cheap, and with Windows 7 coming, which by all accounts is what Vista should have been, Microsoft probably has good reason to think their stock ought to improve.
On the other hand, these are troubled times in markets. The markets are heading back to a level that implies, many people think, implausibly high P/Es. The P/Es on the broader market look all right right now--but only if you think that we will return to the record profits of the last few years. This seems unlikely.
Nonetheless, this is a good sign that the credit markets are unlocking. Which is good news for everyone--except, possibly, the United States government. The reason the government can borrow money so cheaply right now is that no one wants to lend to anyone else--too risky. So investors, particularly fund managers who have to stash the stuff somewhere, have been parking it in government debt, driving prices up to the point where the securities offer little to no return. If they start lending to companies again, that will mean higher interest rates for all the money the administration is borrowing. That, in turn, is one of major reasons that Congress and the administration can act as if the deficits don't matter--right now, they don't. It's practically free money.
There are other reasons to worry about our ability to borrow, more on which later. But that's a good place to start.
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Isn't the government going mostly with short term debt? As the cost of that goes up they can go to longer term (10,20,30 year notes) to keep the rates down.
Won't higher rates result in lower inflation, long term?
Yeah, but if private borrowing increases in the amounts that would be necessary to make this a major problem for the government, wouldn't that indicate the credit crisis is over?
Yes it would. That would of course be a very good thing. But even so, it doesn't magically mean tax receipts equal outlays, just that the particular crisis we spent a ton to avoid was avoided.
In particular, I'd look at the late 40s/early 50s tax rates as comparative. We had phenomenally high federal tax rates to pay off WWII. It was worth it to, you know, stop the Nazis, but still very expensive.
Even in the best case scenario, we've traded one problem for another
Question:
Why do we use P/E ratios instead of E/P ratios?
The latter is more logical because it's easier to compare to interest rates and is less likely to cause a divide by zero error.
No good reason.
Anyone loaning money at long term rates today is pretty much guaranteeing themselves massive capital losses in the years ahead.
Interest rates eventually have to go up with the government borrowing like this. I can't see how it can be avoided.
Hmmm....
Changing the tax code to jack up the effective tax rate on the foriegn earnings of US corps looks like it's going to happen. Microsoft has a lot of foriegn earnings, debt issuance for a share buyback changes the mix of paper sold against Microsoft in a way that cuts their taxable earnings.....
I guess the revenue estimates from that tax code change should be revised downward. Does anyone think the powers that be will do it? This sure looks like a Laffer curve type process in action. Don't tell the Smartest Man in the World, he'll have an anuyeurism.
Not really. If Microsoft has significant un-repatriated foreign earnings, they will likely get no tax benefit from increased interest deductions since a portion of all deductions (including all interest) will be disallowed under the new proposals. You might not agree with Obama (and on this proposal neither do I) but he ain't dumb. In any case, I doubt any public company would design its optimum capital structure solely (or even primarily) for tax planning purposes.
I doubt any public company would design its optimum capital structure solely (or even primarily) for tax planning purposes.
In fact, the preference for debt over equity is exactly "designing optimum capital structure for tax planning purposes". Except for the case of highly cyclical businesses, where even optimists will forsee occasional problems making bond payments, there isn't much good reason to prefer one particular mix over another, except for the differential tax treatment of interest versus dividends.
Sounds like Congress is about to discover what it's like for the teaser rate on your option ARM to reset. We really do get the government we deserve in America...
Anyone loaning money at long term rates today is pretty much guaranteeing themselves massive capital losses in the years ahead.
Tee-hee! I've just gone long on real estate, 80% financed at 4.5%. I intend to renovate with cash over the next year or two while the construction industry has nothing better to do but go bankrupt and try to sell off excess inventory. When Carter II finishes printing money, I'll be engaged in interest-rate arbitrage, setting up a CD ladder which pays more than my mortgage charges!
In 2012, I'm virtually certain to be better off than today. Won't be voting for Obama anyway.
If private borrowing starts to crowd out Uncle Sam, then we should all pop a bubbly. I'll believe it when it happens.
"I doubt any public company would design its optimum capital structure solely (or even primarily) for tax planning purposes."
I'm covering Capital Structure today in my finance class and will be telling my students the same message that is in every corporate finance textbook - that a company would be crazy not to take into account the massive distortion built into our tax code favoring debt. For decades, stable companies that don't use debt have faced pressure from the markets and their stockholders to take advantage of the enormous debt tax shield. Our tax code deliberately gives companies a strong incentive to have more debt than they might otherwise choose. Companies have to balance this against the higher risk, but the corporate tax advantage of debt is generally considered the #1 factor in optimal capital structure.
By the way, Rum Raisin, do you have a source for what you said about disallowing interest deductions? It would be an interesting example for my class, since such a step would be so unusual (as far as I've ever heard).
It's worth pointing out that it is the extinction of usury laws in the United States from the 1970s-- brought about by the credit card companies-- that have been most to blame for making our economy into a debt-generation vehicle.
Well, they are part of the proposals announced by the administration last week. Details are still awaited but the concept is quite similar to a similar proposal (Sec. 975) in the bill introduced by Charlie Rangel, the Chairman of the House Ways and Means Committee, in 2007 (H.R. 3970). Under the U.S. tax system interest is fungible and relates to all activities of the taxpayer including foreign activities. Currently the rules provide that a U.S. taxpayer allocate its interest expense to the foreign income actually recognized in its tax return for the year. Even if interest expense allocated to foreign income exceeds foreign income recognized in the current tax return, the taxpayer can deduct such expense (there are other complications in crediting future foreign taxes). The proposal intends to change this by allocating interest expense (and other common and/or foreign related expenses) to all foreign income including un-repatriated income, and then temporarily disallowing deductions for the foreign earnings not recognized in the current tax return. As evident this would be quite detrimental to corporations with large oversees operations which do not repatriate earnings back to their U.S. parent on a yearly basis.
Well I didn't state that quite correctly. That should read that currently the rules provide that a U.S. taxpayer allocate its interest expense to all activities including foreign activities. As evident the rules are not user friendly.
Thanks for the clarification (even if I'm still a bit confused). In theory, it's a good idea to go against foreign tax 'loopholes', but in practice, it's all pretty complicated.
The Microsoft example is interesting. They've never issued debt before. j mct has a good point that, all else equal, companies with foreign income will have even more of an incentive to shield income any way they can. Perhaps the bill can be structured to stop this - they'll certainly try...
Freddie,
So what you're saying is the poor are stupid and foolish (that's why they are poor) and they need to be protected from themselves?
Our tax code deliberately gives companies a strong incentive to have more debt than they might otherwise choose.
Can you flesh this out a little? Deductibility for interest lowers your effective interest rate slightly somewhat, but does that merely limit the distortion that taxing profits imposes? If I've got a project that can earn 5% and the money is available at 4%, a 20% tax rate with no deduction for interest makes that unprofitable, despite being economically desirable. But make the interest deductible, and now I can go ahead with it.
On the other hand, if I have the cash on hand and nothing better to do with in, debt isn't more attractive because the after-debt-and-taxes return is .8% but the cash financed after-taxes return is 4% (with comparable risk, because if the project fails I could just pay off the debt with my not-spent cash, so my total downside is the same). I pay more taxes, yes, but I take more home, too.
But I'm not a finance professor, so what am I missing?
Rob,
If I've got a project that can earn 5% and the money is available at 4%, a 20% tax rate with no deduction for interest makes that unprofitable, despite being economically desirable. But make the interest deductible, and now I can go ahead with it.
You pay taxes on the profit. If you borrow $1,000,000 at 4% and get a return of 5% your profit after taxes is $10,000, you would then pay 20% of that 10k in taxes or $2,000. Out of the $1,000,000 taxes are only 0.2% in your example.
You pay taxes on the profit. If you borrow $1,000,000 at 4% and get a return of 5% your profit after taxes is $10,000, you would then pay 20% of that 10k in taxes or $2,000. Out of the $1,000,000 taxes are only 0.2% in your example.
I understand that. But what I don't understand is why that makes debt more attractive than cash. If I have $1 million in cash which I invest instead of borrowing, I earn $50k before taxes, pay $10k in taxes, and go home with $40k. Yes, I pay more taxes, but I earn more money because I'm not paying the bank first.
If interest isn't deductible, then with my made-up numbers cash is profitable and debt is unprofitable. If it is deductible, then both cash and debt are profitable, only cash more so. How does this constitute an encouragement to companies to borrow excessively? They can make more money on a given transaction with cash, and as long as they can still make money while borrowing, we shouldn't be trying to stop them.
It seems to me it constitutes an effort to limit the economic damage of taxes by permitting utility-enhancing projects to go forward with debt which taxes would otherwise squelch.
Rob, I don't think I understand all your questions but let me take a crack. Firstly, interest is always tax deductible .. there are limited exceptions but in your hypothetical example it would be deductible. Secondly, companies and their promoters raise capital in the form of debt and equity. Debt has a cost (i.e., interest) which is tax deductible. Equity has a cost as well (i.e., dividends) which is not tax deductible. That is why debt financing generally is considered more tax efficient. Also debt has a fixed cost (in your example the after tax cost is 3.2%), so it is great deal for the equity guys. If the project returns 5%, and assuming all of it can be debt financed, the equity holders (as the residual recipients) get 1.8% for investing nothing. Wouldn't you love a deal where you get 1.8% for basically using someone else' cash? Now in practice, no lender (except maybe Citi) would fund 100% without the promoters putting up some equity. In any case, even if a promoter can fund 100% of a project, in principle, he or she would like some debt financing to spread out the risk.
If you borrow $1,000,000 at 4%, and make $50,000 profit form the investment, you pay $40,000 to the lender, $2000 to the IRS, and have $8,000 left over. If you sell $1,000,000 of stock instead, and issue a 4% dividend, you pay $40,000 to the shareholders, and $10,000 to the IRS (20% of the $50,000 profit, since dividends aren't allowable deductions). Your after-tax profit falls to zero.
If you lower your dividend, then the people with the $1,000,000 are more likely to invest in your competitor who is issuing bonds.
Rob -
Forget the investing side and just look at the financing side of the balance sheet. Microsoft is thinking of issuing debt and using the proceeds to buy back equity [in the filing, they also list 'general corporate purposes' and acquisitions, so we're not 100% sure what they'll do if and when the debt is issued, but for the sake of argument, let's assume they'll go ahead with the stock repurchase].
In other words, Microsoft is thinking of issuing debt purely to retire equity, thus changing their capital structure without changing their investments. This alone could shield large amounts of income from taxes, leaving more money for the remaining shareholders. Microsoft's filing doesn't even give a rough estimate of how much debt they might issue (companies used to have to register a certain amount and pay filing fees, which meant you got an approximate upper limit, but that has changed for well established companies).
So, since I don't have Microsoft numbers to work with, here's an (extreme) example from many years ago:
On July 18, 1986, Colt Industries announced that it was going to take out an extra $1.55 billion in debt at around 11%, and that it would pay a sort of “special dividend” of $85 per share on each of the 19,404,000 shares outstanding. The stock had closed on Friday, July 18 at $66.75/share. On Monday, July 21, Colt’s stock traded at $95 per share.
[Think about it - The stock had been trading at $66.75 per share, so how could it afford to pay out $85 per share?]
If we calculate the debt tax shield on $1.55 billion in new debt at a 34% tax rate (this calculation basically assumes perpetual debt, i.e. they'll keep rolling it over indefinitely), the present value of the tax shield is 34% of $1.55 billion, or $527 million. This comes out to about $27 per share, which explains most of the increase in the stock price. [Note, of course, that the price later fell when the stock went ex-dividend, after the $85 special dividend was paid.]
Does that help? Holding investments constant, you can pay more to securityholders if you give less to the IRS.
This alone could shield large amounts of income from taxes, leaving more money for the remaining shareholders.
I've highlighted the part that I'm confused about. Sure, you shield money from taxes, but you give much, much more money than you save to the lender. I can lower my taxes by making a charitable donation, but I can't make myself better off overall because the donation is, by definition, larger than the tax savings.
If you treat debt and equity and sort of fungible "securities," then yes, you can give more to the combination of stockholders and lenders if you replace equity with debt. But you can't make your business healthier that way, and you can't make your existing stockholders better off. Note that the residual stock value of debt-heavy Colt appears to have been $10/share, 15% of its pre-debt value.
Or am I just naive for thinking better business and shareholder value is the goal?
Regarding debt equity financing, I agree with Ann above. However, just want to add one point. While interest might be tax deductible for the debtor, it is taxable to the recipient. So the government does not loose out on the tax side. While the company pays less tax because of the interest deduction, the interest earners (presumbaly some financial institution) has to pay tax on it. So the government does not care if you debt finance or equity finance. However, the government does care a lot if the business is foreign owned, since debt financing by a foreign owner creates interest deductions in U.S. while the interest income is usually not taxed by the U.S. due to tax treaties or other exemptions. Accordingly, there are limitations on deductibility of interest paid to foreign owners of a U.S. business.
Rob:
Look at it this way. You can hold MSFT bonds or stock, or both. The amount of the value of the bonds and stock together are commesurate to the cash that can be paid out to the holders of the paper. If MSFT subs some bonds for stock, it will be paying out less to the govt in taxes, therefore the holders of the paper, i.e. you, get more. Thus it's a do.
They've lowered the tax rate at your level for divs versus interest, so for you it might not matter all that much, but if you're CALPERS, you don't care about that.
Rob,
"Or am I just naive for thinking better business and shareholder value is the goal?"
The key would be to use your $85 a share dividend to buy some of those 11% Colt bonds.
Rob - As jmo3 pointed out, you have to consider both the fact that Colt's stock ultimately traded at about $10 or $11, and that the stockholders got $85 cash. That still seems better than $66.75 per share (although, once you calculate personal taxes, as Rum Raisin said, it's not as clear that all stockholders were strictly better off, since some might have delayed their capital gains taxes until selling their shares, whereas they had to pay taxes that year for their special dividend).
"Sure, you shield money from taxes, but you give much, much more money than you save to the lender."
You're right that leverage is only worthwhile if you can invest in something with a rate of return above the cost of debt (and, for that matter, at least high enough to pay a reasonable return both to debtholders and to equityholders). In Microsoft's case, they're not investing, they're strictly changing who has claims to what they've already invested. They'll use the proceeds from the debt to buy out some equityholders completely. Before, those stockholders expected a certain rate of return per share (through either dividends or capital gains). Afterwards, there will be more debtholders but fewer stockholders to pay, plus less money will go to the government
Thanks to everyone who helped me to understand this. My problem is that I model everything in my head as a small business deciding to produce something to sell rather than as cash flows on an income statement. My goal is to avoid the money illusion, but clearly when you're dealing with huge public corporations and the tax law, the model fails.
So what you're saying is the poor are stupid and foolish (that's why they are poor) and they need to be protected from themselves?
This is a parody of a blog comment, but oh well-- it's been very well documented that the credit crunch and housing bust were propelled principally by the middle class and affluent. I can't even imagine how someone could come around to thinking a housing bubble could be brought about by the poor.
I think the idea is to establish a right to extensive government funded healthcare now, so that it can never be taken away, and worry about the very difficult task of paying for it later when it becomes a crisis. How else are these things supposed to go?