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Published byEdgar Myers Modified over 9 years ago
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Taxes and Financial Innovation
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Overview Basic tax features & security design Debt versus equity, revisited Options & put-call parity Monetizing a gain
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Basic Features of Income Timing –Realization (“wait-and-see”) –Accrual Character –Ordinary or capital –Dividend or interest Source (Foreign or Domestic)
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Selective Realization & Tax Planning Lock-in effect –Time value of deferral Strategic trading –Hold winners, sell losers
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Tax Rules as Inputs Portfolio design (or selection) –Tax arbitrage –Clienteles Security design –Same issues as portfolio design –Add new securities
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Position Diagrams Debt vs. Equity Payoffs depend on the state of the world Simple 2-period model Equity has a different structure than debt
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Equity
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Debt
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Economics Securities with returns that vary with performance are “equity” –Equity has flexibility Securities with relatively fixed payoffs are “debt” –Junior versus senior debt? –Junior debt versus preferred stock?
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Taxation Debt –No tax on return of principal –No firm level tax; deductions on accrual –Investors taxed on accrual Equity –No tax on return of principal –Corporate tax –Investors taxed on dividends or capital gains
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Security Design Create variable payoff securities that qualify as debt Convert relatively fixed payoff equity into being taxed as debt
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Contingent Debt Contingent debt has variable payoffs –Floating interest rates (no big deal) –Commodity price based payoffs –Stock performance Index Another company Contingent interest or principal?
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Taxation of Contingent Debt Control features matter Contingencies are important Original issue discount portion Settling up at the end
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Disney’s Participation Notes Minimum interest payment Revenue contingent payment “Penalties” for not making movies Cap on total payoff
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Disney Notes Payoff diagram? Explain features of the contract? Tax advantage of the contract? –Alternative sources of funds?
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Monthly Income Preferred Stock Trust preferred, etc. Converting “safe” equity into debt for tax purposes Add an intermediary between the firm and the investors
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Non-Unique Cash Flows Position diagrams = options Derivatives = many copies Non-tax analysis Taxation
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Assumptions for Options Common expiration date, T Common exercise price, k No early exercise Stock price, S Position diagrams of future cash flows (ignore sunk costs!) No transaction costs
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Buying a Call
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Writing a Call
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Buying a Put
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Selling a Put
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Owning Stock
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Shorting Stock
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Payoff to Lending
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Payoff to Borrowing
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Taxation of Options Recall from PS #2 Realization-based taxation Premium affects basis Often capital in character Avoids withholding taxes
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Put-Call Parity What is the position diagram for owning a share, buying a put, and writing a call? Replicates lending Implications for no arbitrage asset pricing? Implications for option prices?
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Share, Put and Short Call
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Put-Call Parity & Taxation S + P - C = B Everything on the left is taxed on realization but the bond is taxed on accrual Same pre-tax cash flows; different taxes OOPS!
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Routes around Realization Shorting-against-the-box –Investor shorts a stock already in portfolio –Borrows stock from broker –Eliminates “risk” –Until 1997, not deemed a realization event “Portfolio” of derivatives -- puts & calls
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Monetizing a Gain Eli Broad has substantial SunAmerica stock Large capital gain Wants cash & possibly diversification Does not want to pay capital gains tax Solution: Strypes Structured yield product exchangable for common stock
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Strypes Buyer pays $56, roughly the SunAmerica share price Buyer “receives” –Interest payments of 6.75% of $56 for 3 years –Value of SunAmerica if less than $76 OR $76 if share price > $76 –Does not receive the dividends
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Decompose Strypes Buyer pays $56 for a portfolio of: –SunAmerica share (no voting rights) –Writes a 3-year call option, strike = $76 –“Swaps” dividend for 6.75% fixed interest At year 3, buyer must sell security Decomposition is not unique
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Strypes: Issuer’s Perspective Retains voting control Might get interest deductions (corporate issuer might even get the DRD) Avoids (defers) tax on capital gain Retains upside potential Sheds downside risk
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