Financial Leverage, Taxation, and the Maximization of Investment Value

Abstract

This paper uses a model of value maximization to derive a condition for the optimal amount of financial leverage to maximize the value of equity for a real estate investment entity. Both untaxed entities and taxed entities have a strong incentive to use financial leverage. If investment returns are taxed at a rate that is lower than the rate at which interest payments can be deducted, the value-maximizing scale of investment is larger than in the absence of taxation. The example of a mezzanine loan added to a base loan is included.

Keywords:

• Equity
• value maximization
• financial leverage
• taxation and leverage

Notes

1 Alternatively, the lender rations credit up to a certain amount of leverage because charging a higher interest rate may make it less likely that the borrower will be able to make the interest and amortization payments. See McDonald (1999) for a detailed analysis of this possibility. Also, mezzanine loans with high interest rates are used to increase financial leverage beyond that available through standard base loans. The real estate company Heitman (2015) provides an introduction to the current status of mezzanine debt for commercial real estate. Mezzanine debt stands behind senior debt in priority and fills the gap between equity and senior debt. Senior debt can provide from 60% to 75% of the funding needed for investments, and mezzanine can be used to boost lending up to 90%. Currently senior debt is expected to return 4% to 5%, and mezzanine debt yields 7% to 15% depending on the amount of senior debt, the amount of the mezzanine loan, and other risk factors such as the debt service coverage ratio for the investment. Equity has an expected yield of about 16% with senior debt of at least 60%. These basic facts are used in the section on mezzanine loans below.

2 McDonald (2007) derives an equation for optimal financial leverage m for a given expected after-tax rate of return to equity, which states: L = [y – (1-t)i]/(1-t)(di/dm), where L is the proportion of the purchase price borrowed, y is the expected after-tax rate of return to equity, and t is the tax rate applied to investment returns and the rate at which interest payments can be deducted. One conclusion in McDonald (2007) is that if the investor wishes to maintain the same after-tax rate of return to equity when that tax rate increases, the investor increases leverage. For example, suppose y = 0.20, t = 0.25, i = 0.10. In this case m = 1.67/(di/dL). Now suppose the tax rate increases to 0.30. The result is that m = 1.86/(di/dL). However, an increase in leverage in order to maintain the after-tax rate of return to equity does not maximize the value of equity. This paper shows that, in the case of uniform tax treatment of investment returns and deductions for interest payments, value-maximizing leverage does not vary with the tax rate.