Risky Tax Shields and Risky Debt: A Monte Carlo Approach

Abstract:     
I identify three sources of risk for the tax shields: two of them associated to the risk of debt and one associated to the operating risk. I present a set of conditions for defining risky debt associated to cash flow and not to accounting earnings. I explain why realization of tax shields for finite cash flows in any period of time t are correlated to Earnings before Interest and Taxes and are not correlated to interest expenses at time t. I question the validity of Miles and Ezzell proposal.

Using Monte Carlo Simulation I explore the behavior of the four basic cash flows, Earnings before Interest and Taxes plus Other income OI, and interest charges, with eight scenarios applied to a financial planning model. I conclude that the risk of tax shields is Ku, the unlevered cost of equity.

Number of Pages in PDF File: 31

Keywords: Weighted Average Cost of Capital, WACC, firm valuation, tax shields, cash flows, Monte Carlo Simulation, discount rate for tax shields, risky debt, risk of tax shields

JEL Classification: M21, M40, M46, M41, G12, G31, J33

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