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The value of tax shields is NOT equal to the present value of tax shields

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  • Fernandez, Pablo

Abstract

We show that the value of tax shields is the difference between the present values of two different cash flows with their own risk: the present value of taxes for the unlevered company and the present value of taxes for the levered company. For perpetuities without costs of leverage, the value of tax shields is equal to the tax rate times the value of debt. Since the existence of leverage costs is independent of taxes, the value of tax shields when there are no taxes should be negative. We later on look at the case of constant growth and derive similar implications. We then identify 9 valuation theories proposed in the literature to estimate the present value of tax shields and show that only one valuation method is consistent when we look at the case of constant growth and no leverage costs. Three theories provide consistent valuations once leverage costs and growth are allowed for. For constant growth companies, we claim that the value of the tax shield in a world with no leverage cost is the present value of the debt (D) times the tax rate (T) times the required return to the unlevered equity (Ku), discounted at the unlevered cost of equity (Ku): VTS = PV[Ku; D T Ku]. Please note that this does not mean that the appropriate discount for the tax shields is the unlevered cost of equity. We discount D T Ku, which is higher than the shield. This expression arises as the difference of two present values, each with different risk

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 73 (2004)
Issue (Month): 1 (July)
Pages: 145-165

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Handle: RePEc:eee:jfinec:v:73:y:2004:i:1:p:145-165

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Web page: http://www.elsevier.com/locate/inca/505576

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  1. Myers, Stewart C, 1974. "Interactions of Corporate Financing and Investment Decisions-Implications for Capital Budgeting," Journal of Finance, American Finance Association, vol. 29(1), pages 1-25, March.
  2. Richard S Ruback, 2002. "Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows," Financial Management, Financial Management Association, vol. 31(2), Summer.
  3. Kaplan, Steven N & Ruback, Richard S, 1995. " The Valuation of Cash Flow Forecasts: An Empirical Analysis," Journal of Finance, American Finance Association, vol. 50(4), pages 1059-93, September.
  4. 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(03), pages 719-730, September.
  5. 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.
  6. Miles, James A & Ezzell, John R, 1985. " Reformulating Tax Shield Valuation: A Note," Journal of Finance, American Finance Association, vol. 40(5), pages 1485-92, December.
  7. Robert A. Taggart & Jr., 1991. "Consistent valuation and Cost of Capital Expressions With Corporate and Personal Taxes," Financial Management, Financial Management Association, vol. 20(3), Fall.
  8. Lewellen, Wilbur G. & Emery, Douglas R., 1986. "Corporate Debt Management and the Value of the Firm," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(04), pages 415-426, December.
  9. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
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