Tax Shield Valuation Research Articles

Gross and net tax shield valuation

PurposeThe purpose of this paper is to show that distinguishing between gross and net tax shields arising from interest deductions is important to firm valuation. The distinction affects the interpretation but not valuation of tax shields for the famous Miller’s (1977) model with corporate and personal taxes. However, for the well-known Miles and Ezzell’s (1985) model, the authors show that the valuation of tax shields can be materially affected. Implications to the cost of equity and optimal capital structure are discussed.Design/methodology/approachThis paper proposed a simple tax shield clarification that distinguishes between gross and net tax shields. Net tax shields equal gross tax shields minus personal taxes on debt. When an after-tax riskless rate is used to discount shareholders’ tax shields, this distinction affects the interpretation but not valuation results of the Miller’s model. However, when the after-tax unlevered equity rate is used to discount tax shields under the well-known Miles and Ezzell’s (1985) model, the difference between gross and net tax shields can materially affect valuation results. According to the traditional ME model, both gross tax shields and debt interest tax payments (i.e. net tax shields) are discounted at the after-tax unlevered equity rate. By contrast, the proposed revised ME model discounts gross tax shields at the unlevered equity rate but personal taxes on debt income at the riskless rate (like debt payments). Because personal taxes on debt are nontrivial, traditional ME valuation results can noticeably differ from the revised ME model to the extent that after-tax unlevered equity and debt rates differ from one another.FindingsFor comparative purposes, the authors provide numerical examples of the traditional and revised ME models. The following constant tax rates and market discount rates are assumed: Tc=0.30, Tpb=0.20, Tps=0.10, r=0.06, and ρ=0.10. Table I compares these two models’ valuation results. Maximum firm value for the traditional ME model is 7.89 compared to 7.00 for the revised ME model. At a 50 percent leverage ratio, equity value is reduced from 3.71 to 3.49, respectively. Importantly, the traditional ME model suggests that firm value linearly increases with leverage and implies an all-debt capital structure, whereas firm value stays relatively constant as leverage increases in the revised ME model. These capital structure differences arise due to discounting debt tax payments with the unlevered equity rate (riskless rate) in the traditional ME (revised ME) model. Figure 1 graphically summarizes these results by comparing the traditional ME model (thin lines) to the revised ME model (bold lines).Research limitations/implicationsTextbook treatments of leverage gains to firms or projects with corporate and personal taxes should be amended to take into account this previously unrecognized tradeoff. Also, empirical analyses of capital structure are recommended on the sensitivity of leverage ratios to the gross-tax-gain/debt-personal taxes tradeoff.Practical implicationsFinancial managers need to understand how to value interest tax shields on debt in making capital structure decisions, computing the cost of capital, and valuing the firm.Social implicationsThe valuation of interest tax shields in finance is a long-standing controversy. Nobel prize winners Modigliani and Miller (MM) wrote numerous papers on this subject and gained fame from their ideas in this area. However, application of their ideas has changed over time due to the Miles and Ezzell’s (ME) model of firm valuation. The present paper adapts the pathbreaking ideas of MM to the valuation framework of ME. Students and practitioners in finance can benefit by the valuation results in the paper.Originality/valueNo previous studies have recognized the valuation issues resolved in the paper on the application of the popular and contemporary ME model of firm valuation to the MM valuation concepts. The new arguments in the paper are easy to understand and readily applied to firm valuation.

Gross and Net Tax Shield Valuation

This paper shows that distinguishing between gross and net tax shields arising from interest deductions is important to firm valuation. The distinction affects the interpretation but not valuation of tax shields for the famous Miller (1977) model with corporate and personal taxes. However, for the well-known Miles and Ezzell (1985) model, we show that the valuation of tax shields can be materially affected. Implications to the cost of equity and optimal capital structure are discussed.

Valuing the Tax Shield under Asymmetric Taxation

Models on enterprise valuation show that the effective or marginal tax rate (ETR) increases linearly with the debt ratio, implying that tax benefits from debt are very important. Empirical research has repeatedly emphasized that this result cannot be sustained, and that tax benefits are in reality much less relevant to valuation. It is an open question whether this impression can also be maintained within a theoretical model. All theoretical models so far assume that the tax rate is constant and identical for gains and losses. In this paper, we attempt to analytically determine the value of a tax shield assuming that gains and losses are taxed differently. We want to precisely determine the impact of a non-constant tax rate on the value of the tax shield. Previous research could only integrate this asymmetry by employing empirical methods and simulation studies, as an analytical solution had not yet been presented. Looking at a very popular financing policy we are able to present a closed-form solution for the effective tax rate. Our results reveal that this value, instead of being a linear function of the debt ratio, is rather concave, sustaining repeated empirical observations. However, our results also show that the “power” or “strength” of this concavity is not enough to explain the empirical results concerning the impact of the tax shield. Therefore, adding an asymmetric taxation is not enough to determine the empirically observed puzzle of tax shield valuation.

The Impact of Default on Tax Shield Valuation

AbstractIn this paper we develop a model to value debt related tax savings and associated yield rates for debt in a setting where future cash flows are uncertain and follow a stochastic diffusion process. By explicitly modeling a default trigger we find that tax shield values in standard Discounted Cash Flow (DCF) valuation formulas are too high as they do not correctly incorporate the risk of default. Furthermore, we are able to endogenously derive risk-adjusted yield rates, while keeping the overall simple and tractable structure of the DCF approach.

Reconsidering the appropriate discount rate for tax shield valuation

This paper aims at identifying the appropriate discount rate for tax shield valuation in a setting where a partial default is possible and either principal or interest payments are prioritized in default. As a general valuation framework we use the stochastic discount factor. We assume a tax framework with corporate taxes, tax-deductible interest payments of the firm, no taxes on the cancellation of debt and no personal taxes. We strictly decompose the payments owed to the debtholders into interest and principal payments and analyze discount rates of those claims for the different priorities. As a result of the single-period analysis we find that the discount rate for tax savings, i.e., the conditional expected return on tax savings, is always equal to the discount rate of debt only for a proportional loss distribution on interest and principal payments. If losses are distributed according to one of the priority assumptions, the discount rate of tax savings behaves different from the discount rate of debt and both discount rates are equal only in very special cases. Furthermore, we derive qualitative statements for the relation between the discount rate of debt and the discount rate of tax savings assuming certain correlations between the stochastic discount factor and the debt repayments. Finally, we show how the prioritization assumptions can be implemented in a multi-period setting. We obtain for the presented set of assumptions a pricing equation equivalent to the one by Miles and Ezzell (J Finance 40:1485–1492, 1985).

Leverage Return Arbitrage

This paper proves that leverage return is economic profit which will be driven to zero in perfect equilibrium. Leverage return/risk irrelevance can serve as a stepping stone on the way to value-irrelevance, and is the missing key to the MM arbitrage. This paper decrypts the key notation of the MM models, and expounds the difference between (1) the valuation of tax shields and bond valuation (2) slicing and capitalization. Leverage return and the Value of Tax Shields (VTS) can be regarded as a system, and the valuation of tax shields is not independent. The higher leverage returns are, the more MM(1963) overstates VTS. Only when leverage return is zero in perfect equilibrium, can the MM VTS be true.

Valuing the Debt Tax Shield

The tax shield from debt represents a significant proportion of total value for many companies, projects, and transactions. Accurate valuation of the debt tax shield is of more importance than ever as leverage is now commonly used as a source of value added, and there is growing competition in buying assets. Changes in tax rules and more international transactions also make it important to understand to value debt tax under different tax regimes. The increased practical importance of accurate valuation of the debt tax shield has been paralleled by debates among researchers about to do it. The different approaches have large effects on estimated values. In this article, we review these approaches and show their implications for practical debt tax shield valuation. The issue we stress is that each method relies on a few basic assumptions, primarily about the risk of debt tax shields. Picking the most appropriate assumption in any particular situation and then using only those procedures that are consistent with that assumption is the key to good valuation of debt tax shields. Using inconsistent procedures can lead to large errors. The structure of the article is as follows: We start by giving a brief overview of the theory. Then we review the tensions that exist in the how to value tax shields literature. Next, we discuss the practical implications of the various approaches and show by way of an example the large errors that can arise if incorrect and inconsistent valuation methods are used. Finally, we offer our views as to which methods and assumptions are most appropriate in various real world economic settings.

Valuing the Debt Tax Shield

The tax shield from debt represents a significant proportion of total value for many companies, projects, and transactions. Accurate valuation of the debt tax shield is of more importance than ever as leverage is now commonly used as a source of value added, and there is growing competition in buying assets. Changes in tax rules and more international transactions also make it important to understand how to value debt tax shields under different tax regimes. The increased practical importance of accurate valuation of the debt tax shield has been paralleled by debates among researchers about how to do it. The different approaches have large effects on estimated values. In this article, we review these approaches and show their implications for practical debt tax shield valuation. The issue we stress is that each method relies on a few basic assumptions, primarily about the risk of debt tax shields. Picking the most appropriate assumption in any particular situation and then using only those procedures that are consistent with that assumption is the key to good valuation of debt tax shields. Using inconsistent procedures can lead to large errors. The structure of the article is as follows: We start by giving a brief overview of the theory. Then we review the tensions that exist in the “how to value tax shields” literature. Next, we discuss the practical implications of the various approaches and show by way of an example the large errors that can arise if incorrect and inconsistent valuation methods are used. Finally, we offer our views as to which methods and assumptions are most appropriate in various real world economic settings.(This abstract was borrowed from another version of this item.)

A Reconsideration of Tax Shield Valuation

A quarter-century ago, Miles and Ezzell (1980) solved the valuation problem of a firm that follows a constant leverage ratio L = D/S. However, to this day, the proper discounting of free cash flows and the computation of WACC are often misunderstood by scholars and practitioners alike. For example, it is common for textbooks and fairness opinions to discount free cash flows at WACC with beta input Bs = [1 + (1-t)L]Bu, although the latter is not consistent with the assumption of constant leverage. This confusion extends to the valuation of tax shields and the proper implementation of adjusted present value procedures. In this paper, we derive a general result on the value of tax shields, obtain the correct value of tax shields for perpetuities, and state the correct valuation formulas for arbitrary cash flows under a constant leverage financial policy.

A Reconsideration of Tax Shield Valuation

A quarter-century ago, Miles and Ezzell (1980) solved the valuation problem of a firm that follows a constant leverage ratio L = D/S. However, to this day, the proper discounting of free cash flows and the computation of WACC are often misunderstood by scholars and practitioners alike. For example, it is common for textbooks and fairness opinions to discount free cash flows at WACC with beta input βS = [1 + (1 − τ)L]βu, although the latter is not consistent with the assumption of constant leverage. This confusion extends to the valuation of tax shields and the proper implementation of adjusted present value procedures. In this paper, we derive a general result on the value of tax shields, obtain the correct value of tax shields for perpetuities, and state the correct valuation formulas for arbitrary cash flows under a constant leverage financial policy.

The One and Only Standard WACC - Cost of Capital versus Return on Capital

A lot of finance textbooks present calculation of WACC (Weighted Average Cost of Capital) as: WACC = Kd - (1 -/- T)- D % Ke - E %, whereas Kd is opportunity cost of debt before taxes, T is tax rate, D % is percentage of debt to total value, Ke is opportunity cost of equity and E % is percentage of equity to total value. Numerous textbooks state that D % and E % are market values, but the correct interpretation of these values is not sufficiently dealt with: which market values, what D/E-ratio? No matter how the financing is done, there is actually only one standard net WACC.WACC changes in time, one needs an up-to-date WACC, yes indeed, but what and how exactly? In short, many questions still remain, but up to the present they do not have unequivocal answers. The purpose of this paper is to clear up these questions and emphasize in some ideas that usually are overlooked. Famous writers, e.g., Pablo Fernandez, Ignacio Velez-Pareja and Joseph Tham, claim: to calculate the firm's value it is necessary to know the WACC-figure, but to calculate WACC, the firm's value (among other data like the financing profile) is needed. Indeed, one needs to know the WACC in order to calculate the firm's value. However, to calculate WACC, several data are truly needed, just not the firm's value. Many misconceptions exist about firm valuation and the valuation of tax shields (VTS) as well as the correct calculation of WACC.Although Franco Modigliani and Merton Miller (MM for short) were awarded the Nobel Prize in Economics, their Propositions I and II appear to be clearly incorrect. Many theories and much advise is flawed by the demasque of MM's Proposition I (1958, equation 3), which states in the absence of taxes, the firm's value is independent of its debt. The so-called proof given by MM is not a mathematical proof. It was and is a statement that cannot stand the test. Proposition I is not true; re SSRN_ID609102. Consequently, everything based on Proposition I is not true either. This paper repudiates Proposition II, constituting Ke being a cost to the firm and similarly a return to the equity investor. Ke and WACC are measuring costs, just costs. Return and cost values coincide at intersect-points only of clearly divergent return and respectively cost functions.

Comments on 'A Reconsideration of Tax Shield Valuation'

Although Arzac and Glosten (2005) affirm that the value of tax shields depends upon the nature of the equity stochastic process, which, in turn depends upon the free cash flow process, I prove that the value of tax shields depends only upon the nature of the stochastic process of the net increase of debt. Arzac and Glosten (2005) formulate the constant leverage ratio assumption as Dt = L Et. The assumption of Fernandez (2004) is E{Dt}= L E{Et}, being E{bullet} the expected value operator, D the value of debt, E the equity value, and L a constant. Arzac and Glosten (2005) assumption requires continuous debt rebalancing, while mine does not. Under both financial policies, the expected leverage ratio is constant, but the Arzac and Glosten (2005) assumption is too extreme.

Reformulating Tax Shield Valuation: A Note

Reformulating Tax Shield Valuation: A Note

Reformulating Tax Shield Valuation: A Note

ABSTRACTStandard financial theory (in the absence of agency costs and personal taxes) implies that each dollar of debt contributes to the value of the firm in proportion to the firm's tax rate. To derive this result, incremental debt is assumed permanent. This paper shows that when the firm acts to maintain a constant market value leverage ratio, the marginal value of debt financing is much lower than the corporate tax rate. Since Hamada's [2] unlevering procedure for observed equity betas was derived under the assumption of permanent debt, we derive an unlevering procedure consistent with the assumption of a constant leverage ratio.

Tax Shield Valuation and the Capital Structure Decision

Tax Shield Valuation and the Capital Structure Decision

TAX SHIELD VALUATION AND THE CAPITAL STRUCTURE DECISION

The Journal of FinanceVolume 33, Issue 2 p. 650-656 Note TAX SHIELD VALUATION AND THE CAPITAL STRUCTURE DECISION Dwayne Wrightsman, Dwayne Wrightsman Professor of Finance, University of New Hampshire. The author gratefully acknowledges the helpful comments and criticisms of Peter Bird, James Horrigan, Fred Kaen, Graeme Macdonald, Ernesto Miranda, and Mark Rubinstein.Search for more papers by this author Dwayne Wrightsman, Dwayne Wrightsman Professor of Finance, University of New Hampshire. The author gratefully acknowledges the helpful comments and criticisms of Peter Bird, James Horrigan, Fred Kaen, Graeme Macdonald, Ernesto Miranda, and Mark Rubinstein.Search for more papers by this author First published: May 1978 https://doi.org/10.1111/j.1540-6261.1978.tb04876.xCitations: 11 Read the full textAboutPDF ToolsRequest permissionExport citationAdd to favoritesTrack citation ShareShare Give accessShare full text accessShare full-text accessPlease review our Terms and Conditions of Use and check box below to share full-text version of article.I have read and accept the Wiley Online Library Terms and Conditions of UseShareable LinkUse the link below to share a full-text version of this article with your friends and colleagues. Learn more.Copy URL Share a linkShare onFacebookTwitterLinked InRedditWechat Citing Literature Volume33, Issue2May 1978Pages 650-656 RelatedInformation