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The Value of Tax Shields IS Equal to the Present Value of Tax Shields

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  • Cooper, Ian
  • Nyborg, Kjell G

Abstract

In a recent paper, Fernandez (2004a) argues that the present value effect of the tax saving on debt cannot be calculated as simply the present value of the tax shields associated with interest. This contradicts standard results in the literature. It implies that, even though the capital market is complete, value-additivity is violated. As a consequence, adjusted present value formulae of a standard sort cannot be used. Also, it implies that the value of the tax saving differs from conventional estimates by a considerable amount. We reconcile Fernandez's results with standard valuation formulae for the tax saving from debt. We show that, as one would expect, the value of the debt tax saving IS the present value of the tax savings from interest. The apparent violation of value-additivity in the Fernandez paper comes from mixing the Miles-Ezzell and Miller-Modigliani leverage policies.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5182.

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Date of creation: Aug 2005
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Handle: RePEc:cpr:ceprdp:5182

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Keywords: adjusted present value; leverage; tax shields;

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References

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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. Cooper, Ian A. & Nyborg, Kjell G., 2005. "Tax-adjusted discount rates with investor taxes and risky debt," Discussion Papers 2005/15, Department of Business and Management Science, Norwegian School of Economics, revised 20 Sep 2007.
  4. 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.
  5. Mark Grinblatt & Jun Liu, 2002. "Debt Policy, Corporate Taxes, and Discount Rates," NBER Working Papers 9353, National Bureau of Economic Research, Inc.
  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. 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.
  8. 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.
  9. 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.
  10. 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.
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Cited by:
  1. Cooper, Ian A. & Nyborg, Kjell G., 2005. "Tax-adjusted discount rates with investor taxes and risky debt," Discussion Papers 2005/15, Department of Business and Management Science, Norwegian School of Economics, revised 20 Sep 2007.
  2. Qi, Howard, 2011. "Value and capacity of tax shields: An analysis of the slicing approach," Journal of Banking & Finance, Elsevier, vol. 35(1), pages 166-173, January.
  3. Fernandez, Pablo, 2007. "A more realistic valuation: APV and WACC with constant book leverage ratio," IESE Research Papers D/715, IESE Business School.
  4. Tse, Chin-Bun & Rodgers, Timothy, 2011. "Can corporate tax shields explain the long-term borrowing behaviour of Chinese listed firms?," International Review of Financial Analysis, Elsevier, vol. 20(2), pages 103-112, April.
  5. Christian Bach, 2011. "Conservatism in Corporate Valuation," CREATES Research Papers 2011-32, School of Economics and Management, University of Aarhus.
  6. Robert Couch & Michael Dothan & Wei Wu, 2012. "Interest Tax Shields: A Barrier Options Approach," Review of Quantitative Finance and Accounting, Springer, vol. 39(1), pages 123-146, July.
  7. Nicolas Piluso & Gabriel Colletis, 2012. "Shareholder value and equilibrium rate of unemployment," Economics Bulletin, AccessEcon, vol. 32(4), pages 3233-3242.
  8. Fernandez, Pablo, 2005. "Valuing companies with a fixed book-value leverage ratio," IESE Research Papers D/614, IESE Business School.
  9. 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.
  10. Schauten Marc B. J., 2013. "Three discount methods for valuing projects and the required return on equity," Contaduría y Administración:Revista Internacional, Accounting and Management: International Journal, vol. 58(1), pages 63-85, enero-mar.
  11. Andrea Gamba & Leon Gordon & Carmen Aranda Leon, 2008. "Investment Under Uncertainty, Debt and Taxes," Working Papers wpn08-03, Warwick Business School, Finance Group.
  12. Howard Qi & Sheen Liu & Dean Johnson, 2012. "A model for risky cash flows and tax shields," Journal of Economics and Finance, Springer, vol. 36(4), pages 868-881, October.
  13. Fernandez, Pablo, 2005. "The value of tax shields with a fixed book-value leverage ratio," IESE Research Papers D/612, IESE Business School.
  14. Fernandez, Pablo, 2005. "The value of tax shields depends only on the net increases of debt," IESE Research Papers D/613, IESE Business School.
  15. Schosser, Josef, 2008. "Bewertung ohne "Kapitalkosten": Ein arbitragetheoretischer Ansatz zu Unternehmenswert, Kapitalstruktur und persönlicher Besteuerung," Passauer Diskussionspapiere, Betriebswirtschaftliche Reihe 13, University of Passau, Faculty of Business and Economics.
  16. Fernandez, Pablo, 2006. "A general formula for the WACC: A correction," IESE Research Papers D/663, IESE Business School.
  17. Voeller, Dennis & Overesch, Michael, 2008. "The Impact of Personal and Corporate Taxation on Capital Structure Choices," ZEW Discussion Papers 08-020, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  18. Assaf Eisdorfer, 2012. "The firm-specific nature of debt tax shields and optimal corporate investment decisions," Managerial Finance, Emerald Group Publishing, vol. 38(6), pages 560-570, May.
  19. Liu, Yuan-Chi, 2009. "The slicing approach to valuing tax shields," Journal of Banking & Finance, Elsevier, vol. 33(6), pages 1069-1078, June.

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