The Valuation of Tax Loss Carryforwards

Abstract

This article shows that future tax savings from a tax loss carryforward equal a portfolio of options based on the taxable base. Unfortunately, the assumption of a geometric Brownian motion is not applicable for the taxable base, since it implies that a positive taxable base, for example, will never become negative and vice versa. Therefore, the famous Black and Scholes formula cannot be used for valuing this portfolio of options. In order to solve this problem, we assume an arithmetic Brownian motion for the taxable base and derive a formula for valuing tax loss carryforwards within a single-period model. In a multiperiod context, a Monte-Carlo simulation based on our findings provides reasonable results. This methodology can also be used to value the tax shields arising from debt if the interest expenses cannot be used in full during the period in which they occur. Our simulation suggests that the assumption that interest expenses are immediately deductable will yield inadequate company values.