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The correct value of tax shields: An analysis of 23 theories

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  • Fernandez, Pablo

    ()
    (IESE Business School)

Abstract

This paper provides guidelines to evaluate the appropriateness of 23 different valuation methods for estimating the present value of tax shields. We first show that the value of tax shields is the difference between the present values of two different cash flows with their own risks: the present value of taxes for the unlevered company and the present value of taxes for the levered company. This implies, as a first guideline, that, for the particular case of a perpetuity and a world without costs of leverage, the value of tax shields is equal to the tax rate times the value of debt. The value of tax shields can be lower when costs of leverage exist. In that case, we show that, since the existence of leverage costs is independent of taxes, a second guideline for the appropriateness of the valuation method should be that the value of tax shields, when there are no taxes, is negative. We then look at the case of constant growth and derive similar conclusions. Second, we identify 23 valuation theories proposed in the literature to estimate the present value of tax shields and illustrate their performance relative to the proposed guidelines. Eight of these theories do not satisfy the two proposed guidelines for the case of perpetuities. Only one of the valuation methods is consistent with these restrictions when we look at the case of constant growth and no leverage costs. Two theories provide consistent valuations when we allow for leverage costs and growth. Finally, we use the 23 theories to value a hypothetical firm and show remarkable differences in the values obtained, which demonstrates the importance of using a method consistent with the proposed guidelines.

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Bibliographic Info

Paper provided by IESE Business School in its series IESE Research Papers with number D/628.

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Length: 28 pages
Date of creation: 13 May 2006
Date of revision:
Handle: RePEc:ebg:iesewp:d-0628

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Postal: IESE Business School, Av Pearson 21, 08034 Barcelona, SPAIN
Web page: http://www.iese.edu/
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Related research

Keywords: value tax shields; valuation theories; valuation methods;

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References

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  1. 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.
  2. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
  3. 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.
  4. Fernández , Pablo, 2002. "Valuing companies by cash flow discounting: Ten methods and nine theories," IESE Research Papers D/451, IESE Business School.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
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