Download pdf - Understanding the Economics of Leveraged ESOPS

CFA Institute

Understanding the Economics of Leveraged ESOPSAuthor(s): Howard A. FreimanSource: Financial Analysts Journal, Vol. 46, No. 2 (Mar. - Apr., 1990), pp. 51-55+67Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479314 .

Accessed: 14/06/2014 23:11

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial AnalystsJournal.

http://www.jstor.org

This content downloaded from 195.34.79.176 on Sat, 14 Jun 2014 23:11:27 PMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=cfa

http://www.jstor.org/stable/4479314?origin=JSTOR-pdf

http://www.jstor.org/page/info/about/policies/terms.jsp


by Howard A. Freiman

Understanding the Economics of Leveraged ESOPS

Leveraged employee stock ownership plans (ESOPs) can be extremely useful as an antitakeover device or an employee motivational tool. But the actual economic benefits of a leveraged ESOP are complex and not as attractive as they may at first appear.

In a leveraged ESOP, a corporation receives a tax deduction not only for interest payments, but also for principal payments. This may seem to be a tax advantage. In fact, however, the deduction for principal payments is merely equivalent to a tax deduction for employee compensation. Furthermore, the deduction is pegged to the stock price at the time of the ESOP's establishment; thus, when stock prices increase, a leveraged ESOP receives a significantly smaller tax deduction than does a corporation with an equivalent capital structure providing an equal amount of employee benefits.

Leveraged ESOPs also receive a tax deduction on stock dividends paid out to employees or used to pay down the ESOP debt. This represents a true tax savings only for allocated ESOP shares. Taking a tax deduction on unallocated ESOP dividends is again equivalent to a tax deduction for employee compensation.

With a leveraged ESOP, a company commits itself to a specific benefit funding schedule over the ESOP's life. If the company's condition deteriorates, it could find itself wed to a very expensive financing vehicle.

L EVERAGED EMPLOYEE STOCK OWN- ERSHIP PLANS (ESOPs) were among the most popular corporate and pension fi-

nance techniques of 1989. New ESOP loans approached $25 billion last year, compared with $6.5 billion in 1988.1 Why did public corporations suddenly rush headlong to adopt a financing technique that has been well known for years?

Three reasons come to mind.

* Delaware law, coupled with an early 1989 Delaware court decision, enhanced the per- ception that leveraged ESOPs are useful as antitakeover devices.2

* Employee-owners are believed to be more productive than other employees.

* A leveraged ESOP is perceived as having economic benefits.

ESOPs and their use as antitakeover devices have been considered extensively elsewhere.3 This article examines in detail the economic value of a leveraged ESOP's tax benefits and considers the qualitative economic issues associated with the technique.

Tax Benefits The economic benefits associated with leveraged ESOPs appear to be straightforward and obvious. Corporations receive a tax deduction on principal repayments, a tax deduction for dividends paid on ESOP stock, and lower borrowing costs. But the true economic value of these benefits is subject to misinterpretation. A full evaluation of a leveraged ESOP requires that

1. Footnotes appear at end of article.

Howard Freiman is Vice President of Fidelity Management Trust Company.

The author thanks Larry Bader, Peter Klosowicz, Ted Rhodes and Mark Wolfson for their helpful comments.

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1990 E 51



corporate treasurers and security analysts ask, "What is the cost of providing an equivalent employee benefit without changing the company's capital structure?"

Principal Repayment Tax Deduction In a leveraged ESOP, a corporation deducts

not only its interest payments, but also its principal payments. The view that this greatly reduces a corporation's after-tax debt service cost is misleading. In fact, the corporation is simply taking a tax deduction for compensation paid to its employees through the ESOP.4

As the corporation repays the loan, stock is allocated to employees' accounts. This stock represents an employee benefit. But the corporation does not receive a tax deduction for this form of benefit; the corporation receives a deduction only for the loan repayment. Moreover, the corporation bases its tax deduction on the stock price at the time of the ESOP's establishment. Thus, if the stock price increases, the corporation receives a significantly smaller tax deduction from the leveraged ESOP than it would have received had it kept an equivalent capital structure and provided an equal amount of employee benefits.

Consider two companies, A and B, with the same financial statements. Both have 34 per cent marginal tax rates and identical $100-per-share stock prices, which move in tandem.

* Company A establishes a leveraged ESOP, borrows $100 million, purchases 1,000,000 shares on the open market and places the shares in the ESOP suspense account. Each year, it repays $10 million of loan principal and allocates 1/10th of the stock (100,000 shares) to employees.

* Company B establishes an unleveraged ESOP, borrows $100 million, purchases 1,000,000 shares on the open market and uses the shares as treasury stock.5 Each year, it repays $10 million of corporate debt and contributes 100,000 shares to employee accounts within the ESOP.

The economic capital structure and the employee benefits of the two firms remain the same.6 Both companies initially replace $100 million of equity with $100 million of debt. Over time, they repay the debt and allocate shares to employee accounts, restoring the equity.

Assume that the stocks do not appreciate over the first year. The employees of each company

Table I Present Value of Tax Benefit to Leveraged ESOP vs. Unleveraged ESOP (at 12% discount rate)

Annual Stock Tax Benefit Price Change (millions)

-10% $ 6.1 -5 3.5

0 0.0 +5 -4.5

+10 -10.4 +15 -18.1 +20 -28.1

thus receive a benefit of $10 million, and both companies have identical tax benefits of $3.4 million, as they each receive a deduction for providing employee benefits. The leveraged ESOP provides no additional tax benefits over the unleveraged ESOP. (Furthermore, both companies pay identical amounts of deductible interest; Company A's interest takes the form of a deductible ESOP contribution, while Com- pany B's interest is a direct payment to credi- tors.)

Assume that, in the second year, the price of each company's stock rises to $105 per share. Both companies provide employee benefits to- taling $10.5 million. However, Company B receives a tax benefit of $3.6 million (34 per cent of $10.5 million), while Company A receives a tax benefit of only $3.4 million (34 per cent of the ESOP loan principal repayment). When stock prices increase, a leveraged ESOP receives a significantly smaller tax deduction than an unleveraged ESOP for providing an equal amount of employee benefits. This is because the tax deduction associated with the employee allocation is limited to the stock price at the ESOP's establishment, which equals the ESOP loan principal repayment.

Table I illustrates the differences between the present values of the tax benefits from leveraged and unleveraged ESOPs, given various annual changes in stock price. Note that this cost can be substantial, even with only moderate increases in the price of a company's stock. Furthermore, these present value results remain proportion- ately similar, even if both companies use stock price appreciation to reduce the number of shares annually allocated to employees.

Some ESOP proponents claim that the tax benefit loss is not a true economic loss, because the company is able to prefund employee benefits at the stock's original cost. As our example

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1990 [ 52



shows, however, a company can achieve the same prefunding result, as well as substantially greater tax deductions, by simply holding the shares as treasury stock, instead of placing the shares into the ESOP suspense account.

Dividend Payment Tax Deduction Corporations can take a tax deduction on

ESOP stock dividends if these are paid out to employees or used to pay down leveraged ESOP debt. What is the economic value of this tax deduction?

Consider again our two companies, A and B, with the same financial statements but with Company A establishing a leveraged ESOP and Company B an unleveraged ESOP. Each company's stock price remains constant at $100 per share, and the dividend rate on each company's stock is $5.

In the first year, Company A uses a combina- tion of $5 million of dividends on ESOP stock (paid in cash) and $5 million of additional cash to repay the ESOP loan. Company B, also with a net $10 million outlay, repays $10 million of debt but does not have to pay $5 million of dividends on treasury stock. Both companies have identical tax savings of $3.4 million. Com- pany A gains no economic advantage by using dividends on unallocated shares to repay an ESOP loan; it simply receives a tax deduction for allocating stock to employee accounts.

If anything, the leveraged ESOP may have some downside. Dividends on unallocated shares, used to repay leveraged ESOP loans, allocate stock at original cost. As noted earlier, this allocation will penalize Company A compared with Company B when stock prices appreciate.

At the beginning of the second year, both companies have 100,000 shares of stock allocated to employees in the ESOP. Company A uses the dividends on these shares to repay the ESOP loan (thereby allocating additional stock to employees' accounts). Company B uses the dividends to allow employees to purchase additional company stock within the ESOP. Again, corporate cash flow is the same. Company A, however, by taking a tax deduction on dividends on shares held in employees' accounts, receives an incremental tax benefit of $170,000 ($10 million x 0.05 x 0.34). Company B receives no equivalent tax deduction.

Company A receives a true economic benefit by taking a tax deduction for dividends on

Table II Present Value of Tax Benefit to Leveraged ESOP from Dividends on Allocated Shares (12% discount rate)

Dividend Rate Tax Benefit (millions) 3% $2.4 4 3.2 5 4.0 6 4.8 7 5.6 8 6.4 9 7.2

allocated leveraged ESOP shares. This tax savings will grow over the ESOP's 10-year life. Table II shows the present value of the tax benefit, which is dependent on the dividend rate.

Companies receive tax deductions on either leveraged or unleveraged ESOP share dividends paid out currently to employees. Company B could usually replicate the leveraged ESOP tax advantage by paying out dividends on company stock to employees. In doing so, the company would be replacing a tax-deferred employee benefit with a currently taxable benefit. It could offset the effects of this change by lowering wages by the dividend amount and making an additional stock contribution to employee accounts within a defined contribution plan.7 (This assumes that Company B is not already at its maximum contribution limits under Internal Revenue Code Sections 404 (a) and 415.) These actions would fully negate the dividend-related tax advantage of a leveraged ESOP over an unleveraged ESOP.

Lower Interest Rate Before the Omnibus Budget Reconciliation

Act of 1989 (OBRA), eligible ESOP lenders could exclude 50 per cent of interest income on all ESOP loans.8 Under OBRA, however, the interest exclusion is not available for new ESOP loans unless the ESOP owns more than 50 per cent of the company's stock.

The lower interest rate associated with leveraged ESOP borrowings represents true cash- flow savings to lenders. The extent to which lenders pass these savings on to corporations depends on the corporate demand for ESOP loans and the tax appetite of eligible ESOP lenders. Before OBRA, a corporation could have replicated the savings by borrowing through an unleveraged ESOP.

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1990 O 53



Table III ESOP Loan Balances (millions of dollars)

End of Year Company A Company B

0 $100 $ 0 1 90 10 2 80 20 3 70 30 4 60 40 5 50 50 6 40 60 7 30 70 8 20 70 9 10 70

10 0 70 11 60 12 50 13 40 14 30 15 20 16 10 17 0

Consider again Companies A and B with the leveraged and unleveraged ESOPs, respec- tively. In every year after establishing the unleveraged ESOP, Company B replaces an additional $10 million of corporate debt with an "immediate-allocation ESOP loan." This is a corporate loan that provides lenders the 50 per cent ESOP interest exclusion for up to seven years. If Company B has outstanding debt at the time of its contribution, it may convert its borrowing to a tax-favored, immediate-allocation ESOP loan.

Table III presents the annual ESOP loan balances for the two companies. Initially, the leveraged ESOP loan balance is larger than the immediate-allocation ESOP loan. By the end of year 5, however, this situation is reversed. As- suming that the corporation saves 50 after-tax basis points on the loan interest rate, Table IV

Table IV Savings from Lower ESOP Loan Interest Rate (millions of dollars)

Present Present Discount Value Value

Rate Company A Company B

6% $2.0 $2.2 7 2.0 2.0 8 1.9 1.8 9 1.9 1.7

10 1.8 1.6 11 1.8 1.5 12 1.7 1.4 13 1.7 1.3 14 1.6 1.2 15 1.6 1.1

gives the present-value savings to the two companies.9

While the tax savings associated with the lower interest rate on a leveraged ESOP loan are substantial ($1.7 million at a 12 per cent discount rate), the savings can almost be replicated by use of an immediate-allocation loan with an unleveraged ESOP ($1.4 million at a 12 per cent discount rate). At extremely low discount rates, the immediate-allocation loan is actually supe- rior.

Other Issues An obvious disadvantage of any ESOP structure is that the investments are concentrated in a single security. Other defined contribution plans usually offer employees the option of holding less risky securities, such as Guaran- teed Investment Contracts or a diversified equity portfolio.10 Furthermore, the strong corre- lation between ESOP stock performance and employee income exacerbates the risk for employees. Employees may value these risks and demand compensation, or an implicit or explicit corporate guarantee.

Not even a lower-risk convertible preferred security combined with a corporate guarantee can fully protect workers in all circumstances. A laid-off employee of a company with a deterio- rating business outlook, for example, not only loses his job, but also a portion of his retirement income.

Reduction in Workforce A major problem of leveraged ESOPs is that

they require a company to specify in advance its contributions to a defined contribution plan. With a growing work force, this prefunding does not present a problem. The actual contribution to all the company's defined contribution plans (including the leveraged ESOP) will be greater than the monies committed in advance to the ESOP.

With a major work force reduction or business downturn, however, the company must continue to make prescribed contributions to meet ESOP debt-service requirements. This can result in a fixed cost, with employees enjoying greater benefits than the company can afford.

Section 861 Considerations For multinational corporations, a leveraged

ESOP may have favorable tax consequences under Internal Revenue Code (IRC) Section 861.

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1990 El 54



Under IRC Section 861, interest expense must usually be allocated to foreign-source income. This reduces a company's foreign-source income and its foreign-tax-credit limit.

Some multinationals, for a variety of reasons, are treating ESOP loan interest as a solely do- mestic expense.'1 In that case, if a company uses ESOP borrowings to reduce other corporate debt, its foreign-tax-credit limit increases.

Tax Law Change It is likely that ESOPs will continue to come

under Congressional scrutiny. Most leveraged ESOP loans before OBRA indemnified the lender against the risk of the loss of the 50 per cent interest exclusion. Under OBRA, favorable grandfathering rules extend this protection to most outstanding ESOP loans.

Not all tax law changes grandfather existing privileges. A future change in the ability of companies to deduct dividends on ESOP shares could turn a leveraged ESOP into a very expensive employee benefit financing mechanism.

Retiree Medical Benefits Leveraged ESOPs have sometimes been her-

alded as a solution to the retiree medical problem. Like any other defined contribution ap- proach to the retiree medical problem, they have the advantage of allowing a corporation to define the benefit commitment as a specified dollar amount in the present. This often allows a corporation to reduce and control its long-term retiree medical benefit expense and liability. For the employee, however, funds distributed from the ESOP are subject to ordinary income tax. Other funding mechanisms allow the employer to provide a tax-free health benefit for retirees. 12

Implications ESOPs can serve a specific corporate finance purpose and be a cornerstone of a company's total employee benefit program. Before imple- menting an ESOP program, however, the corporate treasurer should analyze and understand both the quantitative and qualitative economic issues. Security analysts should recognize the downside risks of this widely heralded technique. E

Footnotes 1. Estimates from Corey Rosen, Executive Director,

National Center for Employee Ownership. 2. Delaware law (Delaware Section 203) prevents

a hostile takeover for three years unless 85 per

cent of "nonaligned" shareholders tender their shares. The law usually defines ESOP-owned shares as nonaligned. In early 1989, Polaroid won a Delaware Chancery Court decision upholding the company's issuance of 14 per cent of its stock to an ESOP before a hostile tender offer by Shamrock Holdings. The decision ruled that the ESOP was "basically fair" to shareholders.

3. For a general overview of ESOPs and their ac- counting, see L. N. Bader and J. A. Hourihan, "The Financial Executive's Guide to ESOPs" (Sa- lomon Brothers, January 1990) and G. H. Gage, K. B. Reilly and R. Wimer, "Employee Stock Ownership Plans in Leveraged Buyout Transac- tions" (Arthur Young, 1988). For a non-technical review of the antitakeover issues, see B. Rice and R. Spring, "ESOP at the Barricades," Barron's, February 6, 1989.

4. For further discussion of this point, see M. S. Scholes and M. A. Wolfson, "To What Extent do Corporations Face Double Taxation?" (Working paper, Salomon Brothers Conference on Corpo- rate Governance, May 22-23, 1989).

5. This example works equally well using a profit- sharing or a 401 (k) plan instead of the unleveraged ESOP.

6. For all analyses in this article, the results will not change if convertible preferred stock replaces common equity.

7. See Scholes and Wolfson, "To What Extent?" op. cit.

8. Both Congressional chambers passed this bill on November 21, 1989. President Bush signed the zbill on December 19, 1989.

9. The theoretical maximum after-tax savings for a corporation with a 10 per cent pre-tax borrowing cost is 135 basis points. This assumes the lender passes through to the corporation 100 per cent of the tax savings. A 7.95 per cent ESOP loan for the lender (at a 17 per cent marginal tax rate) is equivalent to a 10 per cent corporate loan (at a 34 per cent marginal tax rate). Thus the corporate pre-tax savings would be 205 basis points, or an after-tax savings of 135 basis points.

10. The Tax Reform Act of 1986 requires ESOPs to offer partial diversification elections to employees over age 55 with at least 10 years of pension participation.

11. One argument is that ESOP loan interest expense represents compensation expense, which does not have to be allocated to foreign-source income. All the arguments rely on interpretations of the Internal Revenue Code and current IRS regulations. The IRS, however, may seek to treat some of the amounts paid to an ESOP as interest for purposes of the interest-allocation rules.

Freiman footnotes concluded on page 67.




no independent E/P effect across all months. Cook and Rozeff, investigating January and non- January months separately, found both a size and an E/P effect in January and in the rest of the year.

2. The researchers cited in footnote 1 used varying spans over the 1963-83 period. An earlier study of the E/P effect looked only at the 1956-71 period (see S. Basu, "Investment Performance of Com- mon Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothe- sis," Journal of Finance 32 (1977), pp. 663-682).

3. J. Jaffe, D. B. Keim and R. Westerfield, "Earnings Yields, Market Values and Stock Returns," Jour- nal of Finance 54 (1989), pp. 135-148. The data used here are from that paper.

4. As described in Banz and Breen, "Sample- Dependent Results," op. cit.

5. Ibid. 6. The five portfolios formed from securities with

negative earnings are of equal size. Similarly, the 25 portfolios formed from securities with positive earnings are of equal size. However, the number of securities in each of the first five portfolios differs from the number in each of the last 25 portfolios.

7. Basu, "The Relationship between Earnings' Yield," op. cit., and Cook and Rozeff, "Size and Earnings/Price Ratio Anomalies," op. cit., also began tracking in April. Reinganum, "Misspeci- fication," op. cit., started the return period in January, immediately after the grouping period.

8. Although high-E/P firms tend to be small firms, and vice versa, not all low-E/P firms are large firms. Detailed examination of the lowest-E/P firms reveals a heterogeneous mix of very large

(e.g., IBM, Standard Oil of California) and very small firms. Such mixture is conspicuously ab- sent in the other levels of E/P; larger firms occupy the intermediate-E/P levels, while smaller firms dominate the higher-E/P categories.

9. See D. B. Keim, "Size Related Anomalies and Stock Return Seasonality: Further Empirical Evi- dence," Journal of Financial Economics 12 (1983), pp. 13-32.

10. Cook and Rozeff, "Size and Earnings/Price Ratio Anomalies," op. cit.

11. D. B. Keim and R. F. Stambaugh ("Predicting Returns in the Stock and Bond Markets," Journal of Financial Economics 17 (1986), pp. 357-390) con- structed several variables that reflect levels of asset prices and found that these predetermined variables predicted monthly returns on common stocks of firms of various sizes, long-term bonds of various default risks and default-free bonds of various maturies. E. F. Fama and K. French ("Dividend Yields and Expected Stock Returns," Journal of Financial Economics 22 (1988), pp. 3-26) found similar results in regressions using dividend yield as the predicting variable.

12. Ibid., p. 362. 13. We estimated the regressions using weighted

least squares, where the weight used in each regression was the reciprocal of the within- month standard deviation of the daily S&P com- posite. See Keim and Stambaugh, "Predicting Returns," op. cit., for more details on this series and its use in regressions.

14. Keim and Stambaugh present similar evidence for the size effect.

15. Ibid.

Freiman footnotes concluded from page 55.

12. This tax-free benefit is available to employees of companies funding their retiree medical benefits through a pay-as-you-go method, an Internal Revenue Code (IRC) Section 401 (h) arrangement under a pension plan or an IRC Section 501 (c) (9) arrangement. It may be permissible to provide tax-free benefits through a profit-sharing plan. Treasury regulations allow a profit-sharing plan to pay "incidental benefits" such as life, accident or health insurance for the participant and fam-

ily. Under Internal Revenue Code Section 72, qualified plan distributions are taxable unless otherwise excluded. IRC Section 106, however, provides that a contribution by the employer to accident or health plans is excluded from gross income. Also, Internal Revenue Code Section 105 (b) provides that amounts received by an employee through employer-provided health insurance are generally excludible from the employee's income.


