Tax saving's valuation under its appropiate risk profile: A Contingent Claim Approach

Abstract

Tax saving’s valuation is crucial for discounted cash flow valuation and WACC estimation. There is an ongoing debate about the appropriate discount rate for tax savings under CAPM approach. On this paper we evaluate tax savings from a contingent claim approach in order to establish a framework which could be compatible with discounted cash flow valuation while being consistent with tax saving’s nature. We present two approach based on contingent claims with continuous real and risk neutral probabilities, and propose a strategy based on sequential portfolios of European options for its valuation. We state that the value of tax savings is the present value of tax savings, and provide a valuation formula that can be integrated with a traditional discount cash flow model under WACC and APV.