The Value of Tax Shields is Equal to the Present Value of Tax Shields: Further Remarks

Abstract

Fernandez (2004a) and Fernandez (2004b) raise a series of interesting issues about the value of tax savings. However, the central claim, that the value of tax savings from debt cannot be calculated by simply taking the cash flows that arise from the tax saving and present-valuing them, is wrong. The reason is that the result is derived using a mixture of relationships among discount rates and values that cannot simultaneously hold. This paper extends the analysis in Cooper and Nyborg (2004) to the case where a growing version of the Modigliani and Miller debt policy is being followed. It shows that the result derived in Fernandez (2004a) requires the use of an assumption about discount rates that does not hold when this debt policy is being pursued. The paper also presents a general analysis of the assumptions used in Fernandez (2004a) and shows that there is no set of basic assumptions about the cash flows and debt policy of a firm under which all the assumptions hold simultaneously.

Keywords: Tax shields, leverage, adjusted present value

JEL Classification: G31, G32