Financial management when interests on debt are not fully deductable. The Italian case study

Abstract

Purpose: Corporate finance management rules are written under the assumption that financing costs are deductible from taxable income. If this assumption is relaxed, such management rules needs to be revised. How do managers maximise operating margins and returns if this assumption no longer holds true? We faced this issue using both an algebraic and a simulation approach. By defining numerical analysis models, we bypass algebraic profile and skills, which might become too complex for practitioners. Methodology/approach: The recent tax reform introduced in Italy, that creates a partial tax deduction for financing costs, offers a case study. We reviewed traditional management tools and we proposed an analytical model for a simulation approach to measure the effect of these new tax rules on the optimal financial leverage and the maximum firm leverage. Findings: We demonstrate that the new regulation might have a deep impact on not sufficiently profitable companies. We also outline that the regulation is not addressed to highly profitable firms which could be the target for a taxation system aimed to an excess profits redistribution. The recent tax reform ultimately did not address the key issue for the Italian political economy: to strengthen the corporate financial structure and to reduce excess profit generation. Originality/value: We propose a new set of guidelines for financial management wherever financing costs would no longer be deductible from taxable income by linking a well known theoretical framework with a practitioners’ approach.