The Value of Tax Shields and the Risk of the Net Increase of Debt

Abstract

The value of tax shields depends upon the nature of the stochastic process of the net increase of debt, and does not depend upon the nature of the stochastic process of the free cash flow. The value of tax shields in a world with no leverage cost is the tax rate times the debt plus the tax rate times the present value of the net increases of debt. This expression is the difference between the present values of two different cash flows, each with their own risk: the present value of taxes for the unlevered company and the present value of taxes for the levered company. For perpetual debt, the value of tax shields is the debt times the tax rate. When the company forecast to repay the actual debt without issuing new debt, the value of tax shields is the present value of the interest times the tax rate, discounted at the required return to debt.