Value Of Tax Shields Research Articles

Valuing the Interest Tax Shield in the Central European Economies: Panel Data Approach

Capital structure is one of the most frequently discussed issues within Corporate Finance Theory. Optimizing the capital structure and value of the tax shield through the evaluation of its interests can lead to the increasing value of the enterprise, followed by the rising competitiveness and flexibility. The aim of this study is to provide a novel look at the value of the interest tax shield and its determinants in the emerging economies of the Visegrad Four. The model was created on a net sample of nearly 7,000 profitable enterprises between 2015 and 2019 using a one-way fixed effects model of panel data. Regional model results show five main determinants of the debt tax shield (Tangibility, Current Ratio, Gearing, Cost of debt and Size). Others, such as non-debt tax shield, business growth or profitability, are regional, and their impact varies depending on the economic conditions of the countries. The direction of influence of the main determinants indicates that, contrary to the assumed trade-off theory, profitable companies manage the capital structure and the value of tax shield according to the pecking order or modified pecking order theory. The tax shield is made up mostly of interest on short-term loans, which increases the risk of financial distress. There is a hierarchy of funding sources, from trade credit, through shortterm loans, to long-term loans, which are used in the analysed firms to the smallest extent. The structure of liabilities may be considered another determinant of the debt tax shield.

Is the Value of the New Business Tax Shield Lower? Comparative Study of International Valuation Methods

The macroeconomic environment has been characterized by strong GDP growth in recent years. The favourable conditions allow the growth of new innovative businesses (start-ups), which support multiplier economic development. New businesses are often unprofitable in the first years of existence; there is a higher probability of default. The issue of start-ups may be insufficient funding, high costs of financial distress and resulting low corporate value and unattractiveness for investors. The aim of this paper is to analyse and evaluate which of the existing methods of quantifying the debt tax shield is suitable for start-ups. Three different approaches have been chosen to calculate the interest tax shield; Modigliani-Miller (1963) model for imperfect capital markets and two models from Velez-Pareja (2013,2016). The results were obtained by correlation analysis of more than 5,000 Slovak businesses, the impact of the age of the business on the value of tax shield was examined. Also, the impact of the industry on the value of tax shield was explored. The results of the analysis suggest that the quantification by Modigliani-Miller (1963) formula does not take sufficient into account of the age of company. In contrast, the Velez-Pareja (2013, 2016) models are suitable for start-ups, because they take into account the potential tax shield, which occurs when the operating income cannot cover financial costs (especially interest paid). In innovative industries, start-ups often do not reach the traditional tax shield, but their value may be higher using an alternative formula by Velez-Pareja.

The Leverage of Growth Firms

Theories on the capital structure of growth firms produce inconsistent and puzzling results. We revisit the Modigliani and Miller (M&M) theory on capital structure and value of tax shields. Using the M&M’s arbitrage pricing arguments, we are able to extend the theory to growth firms and reconcile the theories of capital structure for growth firms with the M&M theory for no-growth firms. We unify the theories and resolve the puzzles raised in the literature.

Inflexibility and Leverage

Firms' inflexibility to adjust their scale persistently explains capital structure variations in a comprehensive sample and randomly-selected sub-samples. Higher inflexibility leads to lower financial leverage, potentially due to higher default risk and lower value of tax shields. Contraction inflexibility determines leverage more than expansion inflexibility. Moreover, inflexibility explains financial leverage on top of operating leverage variability and cash flow variability. Interestingly, the substitution effect between financial and operating leverage is much weaker among flexible firms. In addition, inflexible firms increase leverage more than flexible firms following a positive credit supply shock, which supports our main findings.

Discontinuous financing based on market values and the value of tax shields

The tax shield as present value of debt-related tax savings plays an important role in firm valuation. Driving the risk of future debt levels, the firm’s strategy to adjust the absolute debt level to future changes of the firm value, labeled as (re-) financing policy, affects the value of tax shields. Standard discounted cash flow (DCF) models offer two simplified (re-) financing policies originally introduced by Modigliani and Miller (MM) as well as Miles and Ezzell (ME). In this paper, we introduce a discontinuous financing policy that refers to the refinancing intervals, i.e., the maturity structure of the firm’s debt. By deriving APV valuation and beta unlevering equations that allow for this discontinuous financing policy, we show the MM and ME policies to be special cases of the proposed extension. While we document the effect of discontinuous refinancing to be economically significant when leverage is high and refinancing periods are extremely long, our results suggest that for low-levered firms with short refinancing periods, the traditional continuous refinancing-based models (like the Miles/Ezzell model) produce relatively robust value estimates. Combining capital structure and maturity structure choices, our model extends the set of feasible financing policies in DCF valuation models.

Valuation and analysis of performance sensitive debt with contingent convertibility

We develop a new type of performance sensitive debt (PSD), called contingent convertible PSD (CPSD), which can be converted into equity in financial distress. We address the pricing of corporate securities and optimal capital structure including CPSD. Most of the results are given explicitly and numerical analyses are provided. The results explain that CPSD is a valuable security in increasing the value of tax shields while keeping default risk in a low level. The firm value is increased due to the issuance of CPSD. The risk-compensating feature of CPSD can alleviate the inefficiencies arising from debt overhang and asset substitution. On the contrary, if equity holders benefit from a conversion, the contingent convertibility will aggravate them. The inefficiencies decrease with the conversion ratio of CPSD.

Production Characteristics, Financial Flexibility, and Capital Structure Decisions

We examine how production flexibility affects financial leverage. A worldwide sample of energy utilities allows us to apply direct measures for production flexibility based on their power plants. We find that production flexibility increases financial leverage. For identification, we exploit privatizations and deregulations of electricity markets, geographical variations in natural resources, the technological evolution of gas-fired power plants, and differences in electricity prices and recapitalization cost across regions. Production flexibility affects financial leverage via the channels of reduced expected cost of financial distress and higher present value of tax shields. The relative importance of these channels depends on firms' profitability.

Production Flexibility, Product Markets, and Capital Structure Decisions

We examine how production flexibility affects financial leverage. A worldwide sample of energy utilities allows us to apply direct measures for production flexibility based on their power plants. We find that production flexibility increases financial leverage. For identification, we exploit privatizations and deregulations of electricity markets, geographical variations in natural resources, the technological evolution of gas-fired power plants, and differences in electricity prices and recapitalization cost across regions. Production flexibility affects financial leverage via the channels of reduced expected cost of financial distress and higher present value of tax shields. The relative importance of these channels depends on firms’ profitability.

(Re-)Financing Policies and the Value of Debt-Related Tax Shields

The tax shield as present value of debt-related tax savings plays an important role in firm valuation. Driving the risk of future debt levels, the firm's strategy to adjust the absolute debt level to future changes of the firm value, labeled as (re-) financing policy, affects the value of tax shields. Standard discounted cash flow (DCF) models offer two simplified (re-) financing policies originally introduced by Modigliani and Miller (MM) as well as Miles and Ezzell (ME). In this paper we show that both policies are special and polar cases of a general model of financing policies referring to the firm's choice of debt refinancing intervals. We derive general valuation and cost of capital equations allowing flexibly incorporating any refinancing sequence. By combining capital structure and maturity structure choices our model extends the set of feasible financing policies in DCF valuation models.

Value of Tax Shields (VTS): 3 Theories with 'Some' Sense

The value of tax shields (VTS) defines the increase in the company’s value as a result of the tax saving obtained by the payment of interest. However, there is no consensus in the existing literature regarding the correct way to compute the VTS. Most authors think of calculating the VTS in terms of the appropriate present value of the tax savings due to interest payments on debt, but Modigliani and Miller (MM) propose discounting the tax savings at the risk-free rate (RF), and Miles and Ezzell (ME) and many others propose discounting these tax savings the first year at the cost of debt and the following years at Ku. We develop valuation formulae for companies that maintain a fixed book-value leverage ratio and argue that, for most companies, and especially when calculating residual values, this assumption is more realistic than those of MM and ME. We obtain an intermediate value between those of MM and ME. If a company targets its leverage in market-value terms, it has less value than if it targets the leverage in book-value terms. How could a manager target leverage in market-value terms? However, many authors identify constant leverage with a constant market leverage ratio.

The implied cost of capital of government’s claim and the present value of tax shields: A numerical example

This paper provides a numerical example of how to calculate the cost of capital of government’s claim (rg) and the present value of tax shields. Schauten and Tans (2006) show for the models used in Myers (1974), Miles and Ezzell (1980) and Harris and Pringle (1985), that the present value of tax shields is equal to the difference between the present value of the expected taxes paid by the unlevered firm and the levered firm, with each of the models’ implied rg as discount rate. We discuss a numerical example using the valuation framework by Schauten and Tans (2006) and give a logic explanation for the low implied rgs of Miles and Ezzell’s and Harris and Pringle’s model.

Valuation of Levered vs Unlevered Firm: The Impact of Debt on Growth Opportunities – Why the APV Equation Could be Misleading

The generally accepted financial theory says that the value of the leveraged firm is equal to the value of the unlevered firm plus the present value of tax shields. This has led to the conclusion that the optimal capital structure (if we ignore bankruptcy and financial distress costs) will theoretically be a 100% debt firm. There is a flaw in the above argument when we extend the concept to high growth firm with reinvestment opportunities. If a high growth firm having ample reinvestment opportunities in high NPV projects opt for the above rationale for capital structure, it would loose these growth opportunities to the extent the debt cash outflow is not available for reinvestment – when compared to an identical unlevered firm. This implies that for levered firms with the return on capital employed greater than the required rate of return for investors, higher equity in capital structure is preferable compared to debt. This paper shows that the Value of Levered Firm is summation of Value of Unlevered Firm, the present value of tax shields and the value of growth opportunities lost when the reinvestment rates of levered and unlevered firms are same. This obvious fact is not very transparent since the conventional APV equation implicitly assumes that the quantum of reinvestment amounts of levered and unlevered firms are identical for comparison. However, when the interest costs of levered firms are sufficiently high and growth opportunites warrant a near maximum reinvestment, the levered firms would not be able to reinvest at the same level as that of unlevered firms. This is illustrated in the paper with an example equating the reinvestment rates instead of reinvestment amounts through a Constant Debt DCF Valuation model (similar to Residual Income Model) (since no econometric study or mathematical proof is necessary).

Interest barrier rules as a response to highly leveraged transactions

PurposeThe tax advantage of debt is considered an important motivation for highly leveraged transactions. The German government limited the tax deductibility of interest expenses to 30.0 percent of earnings before interest, taxes, depreciation, and amortization (the interest barrier rule) in 2008 to reduce the tax incentives for debt financing. This study aims to evaluate the impact of the introduction of the interest barrier rule.Design/methodology/approachThe paper analyzes the changes in the value of the tax shield for German leveraged buyouts as a result of the promulgation of an interest barrier rule. Tax shields are computed to quantify the wealth transfer from taxpayers to corporations.FindingsPrior to the 2008 tax reform, tax shields contributed 8.4 percent to the transaction price, thereby raising the equity value by 33.0 percent on average. With the introduction of the interest barrier rule, the value of tax shields is reduced by 35.1 percent. Affecting more than 75 percent of buyouts, the rule significantly lessens the tax incentive for high levels of debt. The reduction of the corporate tax rate from 31.7 percent to 26.3 percent further lowers the value creation potential. The limited interest deductibility may therefore reduce the number of leveraged buyouts and hence economic growth, unless other non‐debt forms of financing can fulfill the need for capital.Originality/valueAs the first continental European study, this research concentrates on the impact of the German interest barrier rule on value creation in highly leveraged transactions. Conclusions can be drawn in a broader European context.

Interest Tax Shields: A Barrier Options Approach

There is a link between barrier options and tax shields of interest expense. We combine this link with a traditional valuation approach, to present practical valuation formulas for interest tax shields in three debt scenarios with risk of default: (1) constant debt, (2) delayed debt, and (3) debt refinancing. In all cases, default and refinancing are contingent on the random evolution of the income of the firm. For each scenario, we work out sensitivity analysis of the value of tax shields with respect to income, growth, systematic and business risk, risk-free interest rate, interest coverage ratio covenant, and the firm’s refinancing strategy.

From Underleverage to Excess Debt: The Changing Environment of Corporate Debt

We directly estimate the probability of default, the value of tax shields and expected cost of financial distress of firms, using a structural model calibrated and estimated from market prices (CDS and stock price data). This provides for high-frequency data on the major costs and benefits of debt, and allows to derive a unique estimate for target capital structure of firms, if the trade-off theory is valid. Our evidence contradicts the alleged underleverage puzzle, which states that firms are too conservative in their debt policies. We find evidence that over the last decade, firms have been systematically overlevered. This is mainly due to the fact that CDS-implied loss-given-default estimates are far higher than the levels typically assumed in previous studies. In addition, the structural change in the risk-free interest level, which lowered the average level from some 8% to 2%, severely increased the cost of debt without an offsetting effect in tax benefits, thus strongly reducing target debt ratios.

Transfer Prices: A Financial Perspective

AbstractThe arguments for and against transfer pricing schemes so far have focused on profit‐seeking approaches based on tax differentials, or on evasion of government enforced goods and fund flow restrictions. This article shifts to a value‐seeking framework where transfer prices act as strategic tools that may enhance value for the multinational with a foreign affiliate by exploiting financial and/or tax arbitrage that also lead to ownership arbitrage. The results show that there is an optimal level of transfer price depending on the specific exchange rate distribution when the cost structure allows for a penalty for overcharging. Moreover, this article introduces a new form of tax arbitrage benefit of transfer prices that is based on present value of tax shields.

On the risk-neutral value of debt tax shields

The recent interest in the valuation of the benefits from debt financing arises from the disagreement in the financial literature about the meaning of ‘value of tax shields’. Although it is accepted that the tax deductibility of interest increases the value of the firm, the correct valuation of this extra-value is controversial. We adopt a risk-neutral approach to derive a general formula for the value of tax shields. This framework clearly shows that this value equals the summation of the discounted future tax savings. Once we specify a leverage policy and a cash flow dynamics, some well-known formulas are obtained.

Value of Debt Tax Shields in Colombia: An Empirical Study

The Spanish version of this paper can be found http://ssrn.com/abstract=1899685This paper estimates the value of tax shields, using the discounted cash flow method for 23 major non financial firms listed in the Bolsa de Valores de Colombia (Colombian Stock Exchange) between 2001 and 2010 It shows that this value represents on average between 5.40% and 56.73% out of total firm value depending on discount rate for tax shields and calculation method. It also finds that firms’ average leverage is low relative to other countries. Using Data Panel regressions, it explores the behavior of total value of firms and found no evidence that debt creates value.

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.

Taxes, Valuation, and Organizational Structure

This paper estimates the impact of taxes on firm value by taking advantage of a dramatic and completely unanticipated increase in taxes for a group of publicly-traded Canadian firms called income trusts. When the tax rate for income trusts unexpectedly increased from 0% to 31.5%, equity value fell by 21% and firm value fell by 18%, on average. Prospective tax shields mitigate the decline, adding 4.9% to firm value. Consistent with the presence of tax-based investor clienteles, the impact of the tax change depends on the marginal investor’s personal tax status, which influences the value of tax shields. Therefore, simple estimates using the permanent debt approach in the Modigliani and Miller (1963) model substantially overstate the value the market places on tax shields. Finally, this dramatic change in tax policy provides new evidence on the significance of taxes for organizational form choices.