A South African Perspective on the Existence of an Interest Tax Shield

This paper investigates whether the use of debt in the capital structure of a company is beneficial to its shareholders. It fmds that, in the South African context, gearing has no effect on the value of a company. The use of debt can increase the value of a company in a country where capital profits and interest are taxed equally. This is the result of an interest tax shield, which is directly related to the tax deductibility of interest paid. However, when capital growth . and dividends are exempt in the hands of investors, as is the case in South Africa, the interest tax shield does not exist, and there appears to be no benefit in increasing debt. JELM41


SAJEMS NS Vol 3 (2000) No 2
Vu "" the value of a similar company without financial gearing; tc = the company tax rate; Dg the market value of the debt in the geared company; and the interest.rate.

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The interest tax shield (tcD g ) can be defined as the tax saving due to (taxdeductible) interest paid on the debt, capitalized at the pre-taxation interest rate.
• Research conducted by Cooley and Heck (1981: 23-33) amongst financial experts from different sectors of the fmancial and academic world in the USA, indicated that the Modigliani and Miller 1958 article should be regarded as the most significant contribution ever to fmance literature: 85% of 296 respondents included this article as one of the ten most significant contributions to finance literature. This percentage was higher than for any other such contribution to fmance.

PROBLEM STATEMENT AND APPROACH TO THE INVESTIGATION
The questions regarding optimal capital structure and the validity of the Modiglia.l1i-Miller propositions are complicated when approached from a South African perspective. The reason for this is that the majority of the existing literature that deals with the subject originated in the USA and the United Kingdom. There are significant differences between the taxation systems in these countries (especially at the time when Modigliani  The second part of the paper consists of a review of related but independent empirical research to detennine whether the results of these studies support the finding of this paper. Since the four empirical studies were carried out autonomously, they were not designed to specifically test the existence of an interest tax shield. In all four cases though, the studies investigate whether the use of debt in the capital structure is beneficial to the company.

THE VALIDITY OF THE INTEREST TAX SHIELD UNDER SOUTH AFRICAN TAXATION LEGISLATION
When examining the validity of the interest tax shield, a distinction should be made between a taxation system where capital profits are taxed in the hands of the receiver thereof, for example the USA, and a system where these two items are not included in taxable income, such as South Africa.
The theory of the existence of an interest tax shield was developed in a system where capital profits and dividends were taxed in the same manner as normal company profits and interest received (Brealey & Myers, 1996). Several adjustments were subsequently made to account for differences between personal and company tax rates and the effect of unrealised capital profits (Miller, 1977;Brealey & Myers, 1996: 479·84). Nonetheless, the Modigliani and Miller theory regarding the effect of debt in a company's capital structure, in a world with taxes, simply requires that income from debt and equity be taxed at the same rate (Brealey & Myers, 1996: 480).
In terms of the US taxation system, the rate at which interest and dividends received are taxed in the hands of investors, is the same ( In terms of South African tax legislation, dividends received by investors are currently not taxable. Net profit is taxed only once at corporate level, and consequently there is no saving for the investor when a company uses debt. The above can best be illustrated by means of a comparison of how $ or R I million of earnings before interest and tax of a geared and an ungeared company will be distributed amongst debt holders, equity holders and the Receiver of Revenue, under the two tax systems. The first is a system where capital earnings are taxed (as in the USA), whilst in terms of the second dispensation capital earnings are exempt (as in South Africa).
The illustration assumes that debt ofRI million is included in the capital structure of both geared companies at an interest rate of 10%. It also accepts that all after tax income is declared as dividends, and that both the corporate and personal taxation rates are 35%. Secondary Tax on Companies is ignored. It is clear that the Receiver of Revenue receives a smaller share of the income in the case of a geared company under the US tax system. The difference ($22 750) capitalized at the cost of debt before tax, is the present value of the interest tax shield ($22750/0,1 -$227 500). The theory of the tax shield therefore appears to be correct. There is ultimately a saving for the providers of capital when a company uses gearing, and this saving must revert to the equity holders. However, this only appears to apply in a taxation system where dividends and interest received are taxed equally.
We can see from Table 1 that under South Aftican taxation legislation, the debt and equity holders receive no benefit due to gearing. The Receiver of Revenue does not subsidize any of the interest paid. The fact that interest is tax-deductible merely makes it a cheaper form of cOIpOrate finance than it would have been if it had not been tax-deductible.
From the above comparison it can be deduced that under South Aftican tax legislation, the same principles as described in a Modigliani and Miller world without taxes still apply: gearing has no effect on the value of a company.

Introduction
The following four studies have directly or indirectly investigated the effect of the use of debt on the value of South African companies. Davidson and Rapp (1995) inter alia examined the effect of gearing on return on equity and Fasol and Firer (1995) studied the reasons why very few companies were prepared to take up additional debt in an attempt to lower their cost of capital. Whilst Uliana (1993) considered the effect of the debt-equity ratio on the growth of share prices, Shotter, Btiimmer, Dennis and Boshoff (1998) investigated the correlation between shareholders' wealth and capital structure. These studies are reviewed to assess whether the results of independent empirical investigations are consistent with the deduction made in this study. Davidson and Rapp (1995: 90) made an inquiry into the use of debt amongst South African companies. The research population consisted of the Finance Week 200 group of listed companies and the period investigated was from 1989 to 1991.

Davidson and Rapp
They identified two possible reasons for the use of debt: (I) as a method of obtaining finance, and (2) as a technique for regulating the shareholdermanagement relationship. The latter is accomplished when management is forced to pay interest on a regular basis. This prevents them from investing large amounts of cash at their own discretion, which may be detrimental to shareholders (Davidson & Rapp, 1995: 91). Davidson and Rapp (1995: 94) found that financial risk did not affect return on equity. They argued that one of the reasons for this was that there was hardly any tax advantage to the use of debt. They used the formula developed by Miller (1977: 267), D x {I -[(1 -t e )(1 -tps)/(1 tpd)]), where D represents the market value of debt, te the corporate taxation rate, Ips the personal taxation rate on equity income, and tpd the personal taxation rate on interest received, and showed that the advantage of using debt was minimal.
In 1991 Ie was 50%, Ips was nil, and the marginal taxation rate on interest received (Ipd) was 45%. If these values are substituted in the formula, it appears that the tax advantage of debt was minimal-D x 0,0909. In the case where a company's effective taxation rate is lower than the personal taxation rate, the factor with which the debt component is multiplied, becomes negative, with the result that the use of debt is to the company's detriment.
The research conducted by Davidson and Rapp confinns that, due to the absence of an interest tax shield, there appears little advantage in the use of debt.

Fasol and Firer
Fasol and Firer's research (1995: 75) included a sample of 222 listed South African companies. Although 62% of the respondents indicated that they had spare capacity for additional gearing, very few were prepared to take up additional debt in an attempt to lower the company's cost of capital.
The main reasons for this were (1) to maintain a strong cash flow, (2) a lack of good investment opportunities, (3) the negative impact on fmancial ratios, and (4) the perception that additional debt would not decrease, but rather increase, the company's cost of capital. The last aspect supports the view that the use of debt in a capital structure is not beneficial to shareholders in South Africa, which might be ascribed to the fact that an interest tax shield does not exist.

UliaDa
Uliana (1993: 61-8) examined 135 companies listed on the Johannesburg Stock Exchange, to determine the effect of the return on assets and the debt-equity ratio on the growth of each company's share price.
The research covered the period 1987 to 1992, and growth was determined by comparing the share price at the beginning of the period to the value at the end of the period The average prime bank rate during the period of the research was 17,96%, which was lower than the return on assets (Uliana, 1993: 66).
Uliana refers to Zakon's formula (in Uliana, 1993: 61) to determine sustainable growth: == return on assets interest rate te company taxation rate Rp = rate of retention of profits after tax.
According to this formula it is expected that companies with a higher return on assets (Pa) would show higher sustainable growth than companies with a lower return on assets. Similarly, it is anticipated that companies with a high debt.equity ratio would experience higher sustainable growth than companies with a low debt·equity ratio, especially where the return on assets is higher than the interest rate.
The investigation revealed that companies with a higher return on assets (Pa) experienced a significantly higher sustainable growth. This is in accordance with Zakon's formula for sustainable growth. However, with regard to the debt·equity ratio, companies with a lower debt·equity ratio experienced more growth than companies with a higher debt.equity ratio. This is contradictory to Zakon's formula (Uliana, 1993: 65).
Uliana (1993: 66) divided the total sample into two groups, namely the lower debt-equity ratio companies in one group, and the higher debt-equity ratio companies in the other. The results of the research pertaining to the debt.equity analysis can be summarized as follows:  Table 2 shows that neither the return on assets nor the average retention ratio of the two groups differed significantly. Yet the group with the lower debt-equity ratio experienced substantially more growth (3,25 times) than the group with the higher debt-equity ratio (1,77 times).
Uliana's (l993: 66) interpretation of this phenomenon is that sustainable value can only be achieved through fundamental operations such as operational efficiency, and not necessarily through the use of debt.
These findings support the absence of an interest tax shield within the South A Pearson correlation coefficient analysis was performed with market value added as the dependent variable and the other indicators as independent variables. The analysis was carried out at a 1 % level of significance. On the basis of the above data it appears that the strongest correlation over the period as a whole was between MV A and EV A, followed by earnings per share and dividend per share.
The weakest correlation was between MV A and capital structure, namely 0,001. During four of the ten years the correlation was negative. This is inconsistent with Modigliani and Miller's (1963) amended view, that an increase in debt increases shareholders' value.
These results again support the deduction made in this paper, namely that there is little if any advantage to debt within the South African taxation context.

CONCLUSION
There appears to be no benefit to shareholders if the proportion of debt in the capital structure is increased, under South African circumstances. The proposed increase in shareholders' value as suggested by Modigliani and Miller (1963) depends on the existence of an interest tax shield. However, such a shield only arises where capital income and interest are taxed equally, as is the case in the United States of America. In South Africa, dividends and capital growth are exempt in the hands of investors, meaning that an interest tax shield does not exist These fmdings have implications for Financial Management theory and practice in South Africa. Whenever modem capital structure theory is taught or explained in textbooks, the limiting assumptions that accompany these theories should be stressed. If the theory in respect of the existence of the interest tax shield could be modeled on South African circumstances, it would be evident that gearing holds no benefit to shareholders.