The Value of the Tax Shield of Debt

Introduction

Motivation and background

Decisions about optimizing the capital structure of the firm, no matter if it is a small business or a global corporation, has always been an important issue for the management.

Various authors, (e.g. Booth (2002), Cooper and Nyborg (2006), Farber, Gillet and Szafarz (2006)) state that debt policy may only be viewed in terms of maintaining a fixed market value debt ratio (Miles-Ezzell assumption) or a fixed dollar amount of debt (Modigliani-Miller assumption).

The presence of debt financing increases the total cash flow available to debt and equity claimants, as the tax system in most countries allows interest costs to be tax deductible. As a consequence, a levered firm pays less in taxes than does a pure-equity firm, and the sum of the debt plus the equity of the levered firm must be greater than the sole equity of the unlevered firm. The value of the tax shield of debt has gained considerable attention in recent years in real world applications as well as in the academic literature.

The tax shield from debt represents a significant proportion of total value for many companies, projects, and transactions. Its potential size can be seen by considering a company with a 30% debt-to-capital ratio and a corporate tax rate of 40%. One approach to valuing the debt tax shield is simply to multiply the amount of debt by the tax rate, in which case the debt tax shield would be seen as contributing 12% of total value (Cooper, Nyborg 2007). And if the leverage ratio were doubled, the debt tax shield could be shown to contribute almost a quarter of the value of the company. Accurate valuation of the debt tax shield is of more importance than ever as leverage is now commonly used as a source of value add...

... middle of paper ...

...view 48: 261-297.

Modigliani, Franco and Miller, Merton H. 1963. Corporate income taxes and the cost of capital: A correction. American Economic Review 53: 433-443.

Myers, Stewart C. 1977. Determinants of corporate borrowing. Journal of Financial Economics 5: 146-175.

Myers, Stewart C. 1984. The capital structure puzzle. Journal of Finance 39: 575-592. Newbould, Gerald N., Robert E. Chatfield and Ronald F. Anderson. 1992. Leveraged buyouts and tax incentives. Financial Management 21: 50-57.

Ruback, Richard S. 1995. A note on capital cash flow valuation. Harvard Business School Case No. 9-295-069.

Ruback, Richard S. 2002. Capital cash flows: A simple approach to valuing risky cash flows. Financial Management 31: 85-103.

Theis C. 2009 “What is the Value of the Tax Shield of Debt?”

Q-finance journal. 2013 “Understanding Capital Structure Theory: Modigliani and Miller”