A Contribution Towards Integrating Theories of Asset Pricing and Corporate Finance, and Resolving the Tax Shield Puzzle

Abstract

Modigliani and Miller theory, Miller model, Hamada's model, and Conine model for risky debt (all for a zero-growth firm), Daves and Ehrhardt model for growth firm, etc. use conflicting assumptions for the same inputs for valuation, which leads to multiple values of tax shield and equity for the same firm. We show that erroneous use of risk-free rate leads to incorrect model for beta and risk premium in Hamada equation as well as in Conine model and Daves and Ehrhardt model, and lead to multiple conflicting and biased valuations. This paper proposes a corrected model for estimating inputs for the cost of equity that removes conflict in valuation under MM theory, capital asset pricing model, and other valuation theories and holds true for non-zero tax and growth also. The paper contributes towards integration of financial theories and motivates new empirical research on already settled or unresolved issues in asset pricing.