LBOs and Taxes: No One to Blame but Ourselves?

See, for example, Bradley M. Desai A. Kim E. , “Synergistic Gains from Corporate Acquisitions and Their Division between the Stockholders of Target and Acquiring Firms,” Journal of Financial Economics, 21 (1988).

For a review of arguments pro and con, see Newport J. , “LBOs: Greed, Good Business, or Both?” Fortune, January 2, 1989.

Modigliani F. Miller M. , “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review (June 1958).

A statistical study by Schipper and Smith suggests that tax effects are significant in LBOs. They find that tax effects explain about 50% of LBO premiums. However, their analysis rests on LBOs completed prior to the 1986 tax reform. Schipper K. Smith A. , “Corporate Income Tax Effects of Management Buyouts,” Working Paper, Graduate School of Business, University of Chicago, 1988.

The offer was in two stages. First, the acquiring group offered $109 cash per share for 165 million shares. Two months later, a combination of securities with value approximately $80 per share was exchanged for the remaining 58.5 million shares. The net present value of the package approximated $22.5 billion: See Chiu Hwang , op. cit.

The calculation is as follows: Prior to being put in play, the total stock value was $56.20/share x 223.5 million shares = $12.6 billion. Cash and securities worth $22.5 billion were paid to retire these shares, implying a $9.9 billion premium.

Equity amounted to another $1.5 billion, and preferred stock another $3.5–$4.0 billion in market value. Note common stock represents about 5% of total firm value.

Since net income (before interest and taxes) is a random variable in future years, there is a possibility that the full amount of interests payments will not serve to reduce taxes—since losses can only be carried forward. Recognizing the risk that profits might not be as large as interest payments, we discount by the rate paid on the debt—a rate which also reflects the possibility that profits might not be sufficient to pay debtholders.

It should be noted that RJR-Nabisco plans to sell off certain divisions to reduce debt. This makes good sense, since the expected income of RJR is somewhat less than the $3 billion in interest payments, implying that some of the tax shelter is lost. But doesn't it imply lower interest in the future, and thus a lesser amount of tax savings? Not necessarily, since the tax shelter can be effectively be sold if the divisions being sold are themselves bought with debt. Thus, the reduced tax writeoffs from a lower debt service are matched by an increased value in the assets sold, generated by the transferred tax shelter.

Chiu Hwang , op. cit., estimate another $0.5 billion tax saving from inventory writeup, bringing total tax savings to $8.5 billion, or 86% of the premium paid. Lower bond values following the merger (which benefit shareholders accordingly) represent another 3% of value, bringing the total to almost 90% of premium.

This does not affect the 81% ratio, which measures the ratio of tax savings to bid premium as seen from within the firm.

This leads to a chicken-and-egg problem. Did leverage become possible only when the junk bond market developed, or did the junk bond market develop only when leverage became highly desired? Both arguments probably deserve support: The demand and supply undoubtedly developed simultaneously. But surely government tax policy bears a very major role in creating the junk bond market.

This expression assumes that taxable investors (rather than tax-exempt investors) on the margin set price relationships between securities. If τ_e = τ_i, as it does currently, it doesn't matter which of the two groups set relative prices. Miller M. , “Debt and Taxes,” Journal of Finance (May 1977).

Modigliani F. Miller M. , op. cit.

These and subsequent results come from simple arbitrage arguments, in the spirit of the original Modigliani-Miller analysis. They are valid for risky as well as riskless debt, as long as the liquidation costs of bankruptcy are relatively small.

These numbers are approximate, and reflect maximum marginal rates. We ignore state taxes, although for some investors these may be quite important. Note the RJR total tax rate was 40%, not 34%.

Historically, stock returns (capital gains plus dividends) have averaged about 6–8% above the Treasury bill rate. Since in the last 3 years T-bill rates have ranged from 7 to 9%, we find a potential range of 13–17% for expected equity returns.

It has been suggested that, because capital gains can be postponed, the effective rate τ_e is less than stated. In the extreme case where capital gains can be avoided entirely, the above calculations became Δ(pre-86) = .055; Δ(post-86) = .148. Although smaller in absolute value, the impetus to leverage after the tax change is almost three times the impetus before.

The result is determined by [1/(1 -Δ) - 1], which is 0.52 when Δ = .34.

This analysis suggests that firms with underutilized debt capacity are prime candidates for restructuring (or for an LBO). Indeed, the description of the ideal LBO target (“stable revenues, low required investments, liquid assets, and large free cash flow relative to debt service”) is exactly the description of a firm with underutilized debt capacity.

Many “junk bond” financing packages involve floating rate debt. Often this risk is passed through to banks through interest rate caps or collars. This simply moves the economic risks one level back.

It has been suggested that interest deductions for buyouts only be disallowed. Almost surely such a restriction could be circumvented—e.g., the LBO goes through without leverage, and then the firm happens to restructure afterwards. Nor are arbitrary rules limiting deductibility on further leverage likely to be desirable, since they grandfather an advantage to firms which have already restructured.

Some authors, notably Jensen, have argued that the increased incentives provided by high leverage leads to greater management performance “under the gun”. [ Jensen M. , “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” American Economic Review (May 1986).] But this may be a two-edged sword: The sensitivity to firm-specific risks may lead the firm to adopt a much more cautious, short-term management style. Also, equally powerful incentive plans for management can be introduced without imperilling the firm with bankruptcy: Make it clear that “the bums will be fired” if they don't reach certain payout targets (perhaps set equal to the interest payments which the alternatives of greater leverage would entail).

Very recently, the Time-Warner merger has again illustrated the importance of tax benefits in shaping takeovers. Time and Warner had first proposed a pooling-of-interest merger, with no additional leverage. Clearly there were real economic synergies between the firms' activities, and the combined stock values of the two firms rose to reflect this. Time's chairman expressed great pleasure that the deal did not increase the company's debt load. But the failure to use leverage left unclaimed tax benefits “on the table.” Not surprisingly, Paramount rushed to collect the free lunch. It made a $12 billion LBO bid for Time, at a premium of close to 50 percent above the then-current value of Time's shares. Subsequently, Time announced a new and higher offer for Warner using several billion dollars of debt financing, an offer upheld by the Delaware Supreme Court. Despite paying more for Warner, Time's shares remained at a level higher than that after its original bid (but before Paramount's). This can be explained by the tax writeoffs afforded by the debt financing of the final deal.