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Consistent Cash Flow Valuation with Tax†Deductible Debt: a Clarification

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  • Mike Dempsey

Abstract

Massari et al. (2008) argue that the weighted average cost of capital (WACC) approach to discounting expected cash flows is generally inconsistent with the adjusted present value (APV) approach. We show that their argument results from, first, taking a WACC expression that assumes a fixed level of debt in perpetuity and applying it to a scenario where the debt level varies stochastically; and, second, discounting the tax savings from stochastic debt at the rate appropriate for fixed debt. Our paper draws attention to the fundamental proposition by which such errors are avoided when cross†referencing valuation methods. The outcome is that the APV and WACC methods are shown to be algebraically consistent with each other.

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  • Mike Dempsey, 2013. "Consistent Cash Flow Valuation with Tax†Deductible Debt: a Clarification," European Financial Management, European Financial Management Association, vol. 19(4), pages 830-836, September.
    • Handle: RePEc:bla:eufman:v:19:y:2013:i:4:p:830-836
    DOI: 10.1111/j.1468-036X.2011.00625.x
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    1. Cooper, Ian A. & Nyborg, Kjell G., 2006. "The value of tax shields IS equal to the present value of tax shields," Journal of Financial Economics, Elsevier, vol. 81(1), pages 215-225, July.
    2. Enrique R. Arzac & Lawrence R. Glosten, 2005. "A Reconsideration of Tax Shield Valuation," European Financial Management, European Financial Management Association, vol. 11(4), pages 453-461, September.
    3. Ian A. Cooper & Kjell G. Nyborg, 2008. "Tax‐Adjusted Discount Rates with Investor Taxes and Risky Debt," Financial Management, Financial Management Association International, vol. 37(2), pages 365-379, June.
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    8. Isik Inselbag & Howard Kaufold, 1997. "Two Dcf Approaches For Valuing Companies Under Alternative Financing Strategies (And How To Choose Between Them)," Journal of Applied Corporate Finance, Morgan Stanley, vol. 10(1), pages 114-122, March.
    9. Mario Massari & Francesco Roncaglio & Laura Zanetti, 2008. "On the Equivalence between the APV and the wacc Approach in a Growing Leveraged Firm," European Financial Management, European Financial Management Association, vol. 14(1), pages 152-162, January.
    10. Fernandez, Pablo, 2004. "The value of tax shields is NOT equal to the present value of tax shields," Journal of Financial Economics, Elsevier, vol. 73(1), pages 145-165, July.
    11. Miles, James A. & Ezzell, John R., 1980. "The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life: A Clarification," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(3), pages 719-730, September.
    12. Fernandez, Pablo, 2004. "Reply to "The value of tax shields is equal to the present value of tax shields"," IESE Research Papers D/576, IESE Business School.
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    Cited by:

    1. Michael Dempsey, 2015. "Stock Markets, Investments and Corporate Behavior:A Conceptual Framework of Understanding," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number p1007.
    2. Magni, Carlo Alberto & Marchioni, Andrea, 2020. "Average rates of return, working capital, and NPV-consistency in project appraisal: A sensitivity analysis approach," International Journal of Production Economics, Elsevier, vol. 229(C).
    3. Sven Arnold & Alexander Lahmann & Bernhard Schwetzler, 2018. "Discontinuous financing based on market values and the value of tax shields," Business Research, Springer;German Academic Association for Business Research, vol. 11(1), pages 149-171, February.
    4. Carlo Mari & Marcella Marra, 2017. "Deterministic discounting of risky cash-flows," Journal of Finance and Investment Analysis, SCIENPRESS Ltd, vol. 6(3), pages 1-2.
    5. Alexander Lahmann & Maximilian Schreiter & Bernhard Schwetzler, 2018. "Der Einfluss von Insolvenz, Kapitalstruktur und Fremdkapitalfälligkeit auf den Unternehmenswert [The Impact of Default Risk, Capital Structure, and Debt Maturity on Firm Value]," Schmalenbach Journal of Business Research, Springer, vol. 70(1), pages 73-123, March.
    6. Marko Volker Krause & Alexander Lahmann, 2016. "Reconsidering the appropriate discount rate for tax shield valuation," Journal of Business Economics, Springer, vol. 86(5), pages 477-512, July.
    7. Juhász, Péter, 2019. "A súlyozott átlagos tőkeköltség alkalmazásának kihívásai [Challenges in applying the weighted average cost of capital]," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(7), pages 805-823.
    8. Nguyen Kim-Duc & Pham Khanh Nam, 2024. "Consistent valuation: extensions from bankruptcy costs and tax integration with time-varying debt," Review of Quantitative Finance and Accounting, Springer, vol. 62(2), pages 719-754, February.
    9. Michael Dempsey, 2019. "Discounting methods and personal taxes," European Financial Management, European Financial Management Association, vol. 25(2), pages 310-324, March.
    10. Ian A. Cooper & Kjell G. Nyborg, 2018. "Consistent valuation of project finance and LBOs using the flows†to†equity method," European Financial Management, European Financial Management Association, vol. 24(1), pages 34-52, January.

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