tax shield

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Another important component of the corporate tax system is the treatment of losses. A corporation that loses money in a particular year experiences what is known as a net operating loss (NOL). No corporate tax is due when a company has a NOL because they do not have profits (e.g., total income less expenses is negative). In addition, a NOL can be “carried back” and deducted from up to two prior years’ taxable income. The corporation is then eligible for a refund equal to the difference between previously paid taxes and taxes owed after deducting the current year’s loss. If the loss is too large to be fully carried back, it may be “carried forward” for up to 20 years and used to reduce future tax liabilities. Figure 1. Effect of tax benefit on firm’s value (Hickman et al., 1996: 402) the tax shield from debt (TS) generates a cash flow stream that is equal to the corporate tax rate times the risk-free interest payment, Cash flow from TS = τC*rf*D , (2) where rf is the risk-free interest rate and D is the market value of debt. Recall that at issuance, the market value of debt is not necessarily equal to the amount borrowed or to the nominal value. Moreover, the market value of debt might change during the bond’s life. This is important to note, because the literature does not consistently use the same variable to compute the tax savings from debt.4 For simplicity and in order to remain consistency among the different approaches in the literature, it is assumed throughout, if not differently stated, that the market value of debt is equal to the nominal value and therefore also equal to the book value of debt. Brealey, Myers and Allen (2006, 470) and Ruback (2002) use the amount borrowed, Copeland, Weston and Shastri (2005, 560... ... middle of paper ... ...included in the CCF, the discount rate is before-tax and corresponds to the riskiness of the assets (Ruback 2002). In this chapter there were presented three basic discounted cash flow methods for firm valuation that are often used in practice and which explicitly or implicitly include the value of the tax shield of debt. It should be mentioned, as Bertoneche and Federici (2006) and Fernandez (2007a) prove, that the different valuation methods give the same result for total value of the firm as well as for the value of the tax shield of debt, as long as the valuation methods rely on the same hypotheses and do not implicitly include any additional assumptions. Indeed, Fernandez (2007a) notes: “This result is logical, as all the methods analyze the same reality under the same hypotheses; they differ only in the cash flows taken as a starting point for the valuation.”

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