Project sponsors need to consider tax implications when assessing the debt and equity mix as it can impact the cost of capital, earnings, and the source of capital. Interest on debt, if tax deductible, can substantially reduce the overall cost of capital, and combined with the fact that the cost of debt is less than the cost of equity there is an incentive for sponsors to use debt instead of equity to finance projects. The example in Box 2 - 2 shows how substituting equity capital for debt capital can reduce the total cost of capital from 15% to 10.2%. It also shows how that cost is further reduced to 8.9% once the tax benefit of debt is considered.
| Box 2 - 2 The following example compares the weighted cost of capital 18 when only equity financing is used compared to when both equity and debt capital are used but the tax benefits are not factored in, and when both equity and debt capital are used but the tax benefits are factored in. Cost of Debt 7% Cost of Equity 15%19 60% of project costs are financed with debt and 40% with equity Corporate Income Tax Rate = 30% WACC equity only = (15% x 100%) = 15% WACC without tax benefit = (7% x 60%) + (15% x 40%) = 10.2% WACC with tax benefit = (7% x 60% x (1-30%)) + (15% x 40%) = 8.9% |
However, should a government be willing to provide tax holidays on earnings, there might be an opposite incentive to reduce debt financing in favour of equity in the short term.
Box 2 - 3 helps demonstrate the impact of taxes and the use of debt versus equity to the income statement of a project. Project A, with its use of leverage, has lower net income, but offers its shareholders a return on equity (ROE) of 28% whereas Project B shareholders have a higher net income, but a larger tax expenditure and a more modest 15% ROE. However, Project B's ROE increases to 21% with the benefit of a tax-free holiday.
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Box 2 – 3 Consider two projects worth $100 million. One is financed using 60% debt financing the other only 10% debt. Assuming a cost of debt capital of 7% and a 30% tax rate, the income statement may look something like this: |
|||
|
Project A |
Project B |
Project B |
|
|
60% debt / 40% equity |
10% debt / 90% equity |
Tax-free holiday
|
|
|
Revenue |
100 |
100 |
100 |
|
Expenses |
80 |
80 |
80 |
|
20 |
20 |
20 |
|
|
- Interest |
4.2 |
0.7 |
0.7 |
|
15.8 |
19.3 |
19.3 |
|
|
- Tax |
4.74 |
5.79 |
0 |
|
Net Income (EAT) |
11.06 |
13.51 |
19.3 |
|
28% |
15% |
21% |
|
|
Tax Rate 30% |
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In many countries, the interest income earned on bonds is taxable. In turn, some countries, such as the United States and India (see Box 2 - 4), have implemented legislation which enables the issuance of tax-free infrastructure bonds. This legislation helps separate the financing from the ownership structure of the PPP and provides different levels of government easier access to the capital markets.
| Box 2 - 4 In 2001, the Government of India permitted the floatation of a tax-free bond to finance the development of urban infrastructure. The bonds carried an interest rate of 10.5% and a minimum maturity of five years. Bond issuance guidelines stipulated that the maximum amount of tax-free bonds, as a percentage of the total project cost, would be 33% or Rs. 50 crore, whichever was lower. The issuer would also contribute at least 20% of the project cost either from internal sources or from grants, or a mix of the two. The funds raised from the bonds were to be used only for capital investment in the setting up of new projects and expansion or augmentation of existing systems relating to urban infrastructure services including water supply, sewerage, drainage, solid waste management, roads, bridges, and urban transport. Also stipulated, was the issuer's responsibility of setting up an escrow account where revenue proceeds earmarked for debt servicing were to be deposited. United States 22 The United States has legislation allowing the issuance of Municipal Revenue Bonds in order to pay for infrastructure projects. The bonds are interest-bearing obligations issued by state or local governments and secured by the revenue of the projects they fund. Unlike other bonds, Municipal Revenue Bonds are free of federal income taxes on interest distributions and free of state and local taxes in the state in which they are issued.
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Governments and communities have also benefited from innovative tax structures such as Tax Increment Financing Districts (see Box 2 - 5) that have provided a mechanism with which to secure cash flow in order to raise debt financing.
| Box 2 - 5 The creation of tax increment financing funds (TIF) and TIF districts is an innovative way of securing the necessary cash flow in order to raise debt financing for infrastructure projects. Under tax increment financing, project sponsors pay property taxes based on the value of the property prior to any improvements. However, due to the improvements or new infrastructure there is an increase in property values and thus an increase in property taxes within the designated TIF. The difference between the pre-improvement taxes and the new tax amount is directed into a fund, which in turn will go to finance the improvements or service the debt. The TIF system relies on the appreciation in value of the land and buildings in the TIF district. If a development is profitable, then the debt and other costs will be paid for by the growth of property tax revenues. If the property fails to increase in value, the improvement costs fall back on the general taxpayer. Though there is an obvious risk to the taxpayer if the project is not successful, the risk must be weighed against the alternative, which for some communities means no improvements. |
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18 See Appendix 3 - Financial Calculations for a description and methodology of WACC
19 Though 15% is used in this example, the cost of equity capital will vary depending on the source and can be as high as 25% or more.
20 EBIT = Earnings Before Interest and Tax
EBT = Earnings Before Tax
EAT = Earnings After Tax
ROE = Return on Equity
21 http://www.hindu.com/thehindu/2001/02/25/stories/0225000k.htm
22 http://www.bondsonline.com/
23 Melby J. and Hall J. "Tax Increment Financing: An Infrastructure Financing Solution"
24 TIF has been used throughout the state of Ohio in the US, including Columbus, Easton Town Center and Polaris Fashion Place