sou · GMB3136d2 · 1999-01-01 00:00:00 — firm would attempt to carry out an unlimited substitution of new share issues for debt financing, because the solution space is unbounded downwards. This means that the value of the firm would be negative. The household reduces its purchase of bonds to be able to purchase new shares issued by the firm. The firm uses this capital inflow to reduce its net increase in debt. This means that the households miss net interest income, to (1 - tp )a3i SEK. This amount converted to euro is (1 - tp )a3i This loss must be compared to the increase in dividends that the firm can distribute, because of decreasing interest payments. The flow of dividend payments after corporate and personal taxes is equal to (1 - td )(1 - t)a3i SEK, which converted to (1 - td )(1 - t)a3i If the increase in dividends is lower than the net interest income that shareholders miss then the firm will prefer to issue debt instead of issuing new shares. An alternative way of interpreting (2.24) is from the firms point of view. For this we need to re-write expression (2.24) as follows. (1 - tp )a5i (1 - td )(1 - t)a4 On the right hand side of (2.25) (1 - tp )a5i (1 - td )(1 - t)a4 of new share issues in euro. i is the cost of debt. If the net cost of new share issue financing exceeds the cost of debt financing , then the firm will prefer debt to new share issues. The net advantage of the substitution for the case of accounting in home currency can be found by assuming that a3 = a4 = a5 = 1 . (1 - tp )i This implies that ií ý Using (2.1), we can conclude (1 - td )(1 - t) (1 - tp )i that (1 - td )(1 - t) > i Û NI p DF . This means that the firm prefer issuing debt instead of issuing new shares at the (with regard to the Swedish tax system formalized in (2.1). The comparison between the net advantage of substitution in the case of SEK accounting with the net advantage in the case of euro accounting (see (2.25)) imply that the choice at the between debt and retained profits can indeed be altered because of the conversion method. The only way to accomplish exchange rate neutrality in this case has its accounting in SEK is to let compared to the case where the firm a3 = a4 = a5 . However, this is not possible because of some practical problems. 2.2The Overall Financial Optimum In this section, we combine the results achieved in Sections 2.1.1, 2.1.2 and 2.1.3 in order to determine the firms overall financial choice. A tax system is a combination of different tax rates and deduction rules. To find out the firms overall financial optimum we must have knowledge of the tax system. Depending on the tax rules, we get different solutions in the solution space. Depending on the prevailing tax rules in , (2.1), we showed that expressions (2.14), (2.20) and (2.25) NI f RP, DF f RP and DF f NI . > 0 , n f = 0 and n10 > 0 . mentioned in previous section, this results may be altered because of the conversion method. However, in this section, we will assume that the implication of the conversion method does not alter the impact of the taxation system. The observation that nr > 0 , n f = 0 and n10 > 0 is the starting point for this section. In what follows, we will undertake an analysis of whether other constraints in the optimization problem are binding or not. By inserting (2.6) into (1.48), and by a few simplifications, we obtain the following equation for the shadow price of the dividend- ceiling: Inserting (2.7) into (1.49), and by a few simplifications, imply (2.27), we conclusion, namely that n2 = - n9 . However we know that n2 ³ 0 ,which means that the only possibility for n2 = - n9 = - n9 = 0 This means that the firm will have positive current assets and current liabilities, CAe > 0 and CLe > 0 , in steady state. Let us now insert (2.8) into (1.46), which after few simplifications, leads us the following equation for the shadow price of the dividend-ceiling: By inserting (2.26) together with (2.28) into (2.29), we end up with the following conclusion, namely that (n - rra By combining equations (1.50) and (2.9), and by a few simplifications, we solve the following equation for n4 (2.26) and (2.28) imply that indicates that n > 0 which means that RRe Thus, in steady state firms will hold a restricted reserve which fulfill the legislation requirement. Using (2.32), we can rewrite (2.30) as below n3 + rn10 = r(jqa3 + ra5 ) Using (2.33), we conclude that n3 + rn10 > 0 . the case where neither the constraint on new issues of shares nor the constraint on share capital are binding is excluded. In section 2.1, we concluded that n10 > 0 . This means that the constraint on new issues of shares is binding. However in this case there will be situations when the constraint on share capital is not binding. This means that there exist solutions for steady state where the firm decides to not minimize its share capital to the amount demanded by the legislation. Let us now solve a new expression for nr . This can be done by combining equations (2.5) and (1.45) i(1- t)rqa3 Inserting (2.26) together with (2.28) into (2.34) gives us the following expression for n8 n8 = i(1 - t)rqa3 Thus, n8 > 0 which means that firms will not have any long term liabilities in steady state. Combining (1.51) and (2.10), we conclude that n5 = 0 , which means that firms will have a positive free reserves in steady state. Logically firms should have positive assets in a steady state. This means that n1 = 0 . Because of this logical assumption, it is then obvious that n6 = 0 and n7 = 0 . n6 = 0 means that the firms taxable residual value of machinery and equipment is positive. n7 = 0 means that the firm has positive accumulated supplementary deprecations. In the next section, we will use the conclusions in section 2, to derive the cost of capital for the firm. 3 The cost of capital An important question in this paper is how taxation affects the optimal employment of capital. Investment planning and financial planning are highly interrelated and they are determined simultaneously by the firm. In this chapter we apply the previous findings on the firms financial decisions to an analysis of its cost of capital. The cost of capital or the required return is the minimum acceptable rate of return required by shareholders of the firm for undertaking an investment project. Unless the investment generates sufficient funds to repay suppliers of capital, the firms value will suffer. By inserting (2.3) and (2.4) into (1.44), and after a few simplification, we find that rqa3 (1 - t) f M e (r + d) (r + dT ) r èr + dT ø By inserting (2.26) together with (2.28) into (3.1) we can find the solution for the steady state net cost of capital. The net cost of capital can be shown to be (1 - t p )i f M e - d= - tc )(1 - r + d þ With accelerated depreciation ( dT > d) firms can use tax debt (which rises because of accelerated depreciation) as a source of finance for their investment. The proportion of investment that is financed through tax debt is thus equal to t r + dT . The cost of this source of finance is equal to zero. The first term in equation (3.2), is the cost of capital for the proportion of investment that is financed through 1 - t T is the share of the firms investment financed r + d (1 - tp )i through retention. The cost for this source of finance is (1 - tc )(1 - t) . In this paper, we present a conversion method which we believe satisfy the guidelines of the commission. The conversion proposed in this paper is a current rate method. According to this method all balance sheet items are converted using the exchange rate at the end of the accounting year. At the same time the profit and loss for the financial year is converted using the average exchange rate of the financial year. For practical reasons, there are a few exceptions. These regards the firms new issues of shares, its dividend payments, and its allocations to free- and restricted reserves. The firms share issues are converted using the exchange rate at the time of the issue, while its dividend payments and its allocations to free- and restricted reserves are converted using the exchange rate at the time of dividend payments. We were able to show that this method creates different inequalities between the asset- and the liability side of the balance sheet. These inequalities are balanced by a new variable, Conversion differences, at the liability side of the balance sheet. The conversion differences consists of the difference between the average exchange rate and the exchange rate at the balance sheet day multiplied by the net business income. Moreover, we show how the non-arbitrage condition (which gives the value of the firm) is affected by the different exchange rates. By a pair wise comparisons between different long term financial sources, we were able to show that the initial choice at the between different financial sources (which initially is only tax related) can indeed be altered because of the conversion method. We present a theoretical solution that remove this effect. However, we do not propose such solution because of different the practical problems implied by the solution. The results from the pair wise comparison are then used to solve the overall financial optimum. This was done by examining whether the shadow price for different financial and accounting constraints are positive or not in steady state. This analysis indicated that in the long run (in steady state) the firm has positive current assets, positive current liabilities and positive assets (in our case machinery and equipments), which in this case imply that the tax residual value of machinery and equipment, as well as the accumulated supplementary depreciation, are positive. Moreover, it is also shown that the firms will not have any long term liabilities in steady state. The free- and restricted reserves will also be positive. However, the firm will only hold restricted reserves which fulfill the legislation requirement. We also concluded that the case where neither the constraint on new issues of shares nor the constraint on share capital are binding is excluded. Moreover, we showed that the firm will, in the long run, have an incentive to repurchase its own shares. This means that the constraint on new issues of shares is binding. However, in this case there will be situations when the constraint on share capital is not binding. This means that there exist solutions for steady state where the firm decides not to minimize its share capital to the amount demanded by the legislation. Finally, the total cost of capital was shown to be equal to the cost of retention multiplied by the proportion of investment that is financed through retention. It was shown that some of the investment is financed through tax debt which does not cost anything for the firm. The most surprising result in the last section of this paper is that the cost of capital is not affected by the conversion method. However, this is only true under some specific conditions. For the derivation of the cost of capital we assumed that the conversion method will not alter the basic tax oriented choice between different financial sources. But, if we relax this assumption the cost of capital would certainly be affected. 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