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Estimating the Appropriate Risk Profile for the Tax Savings: A Contingent Claim Approach

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  • Gonzalo Diaz Hoyos
  • Ignacio Velez Pareja

Abstract

Tax saving´s valuation is crucial for discounted cash flow valuation and WACC estimation. There is an ongoing debate about the appropriate discount rate for tax savings under CAPM approach. On this paper we evaluate tax savings from a contingent claim approach in order to establish a framework which could be compatible with discounted cash flow valuation while being consistent with tax saving´s nature. We present two approach based on contingent claims with continuous real and risk neutral probabilities, and propose a strategy based on sequential portfolios of European options for its valuation. We state that the value of tax savings is the present value of tax savings, and provide a valuation formula that can be integrated with a traditional discount cash flow model under WACC and APV.

Suggested Citation

  • Gonzalo Diaz Hoyos & Ignacio Velez Pareja, 2010. "Estimating the Appropriate Risk Profile for the Tax Savings: A Contingent Claim Approach," Proyecciones Financieras y Valoración 7417, Master Consultores.
    • Handle: RePEc:col:000463:007417
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    Keywords

    Contingent Pricing; Tax Savings; WACC; Asset Pricing; Rate of Return; Risk Analysis; Discount Rate for Tax Shields; Pricing Kernel; Risk Neutral Probabilities; Stochastic Discount Factor;
    All these keywords.

    JEL classification:

    • C19 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Other
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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