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A Reconsideration of Tax Shield Valuation
Author(s) -
Arzac Enrique R.,
Glosten Lawrence R.
Publication year - 2005
Publication title -
european financial management
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.311
H-Index - 64
eISSN - 1468-036X
pISSN - 1354-7798
DOI - 10.1111/j.1354-7798.2005.00292.x
Subject(s) - perpetuity , free cash flow , valuation (finance) , tax shield , economics , weighted average cost of capital , leverage (statistics) , cash flow , mathematical economics , microeconomics , actuarial science , finance , tax reform , mathematics , public economics , profit (economics) , state income tax , statistics , individual capital , financial capital , gross income
A quarter‐century ago, Miles and Ezzell (1980) solved the valuation problem of a firm that follows a constant leverage ratio L = D/S. However, to this day, the proper discounting of free cash flows and the computation of WACC are often misunderstood by scholars and practitioners alike. For example, it is common for textbooks and fairness opinions to discount free cash flows at WACC with beta input βS = [1 + (1 − τ ) L ] β u , although the latter is not consistent with the assumption of constant leverage. This confusion extends to the valuation of tax shields and the proper implementation of adjusted present value procedures. In this paper, we derive a general result on the value of tax shields, obtain the correct value of tax shields for perpetuities, and state the correct valuation formulas for arbitrary cash flows under a constant leverage financial policy.