Risky Tax Shields and Risky Debt: A Monte Carlo Approach

31 Pages Posted: 27 Jun 2010 Last revised: 10 Aug 2010

See all articles by Ignacio Velez-Pareja

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation

Date Written: August 8, 2010

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.

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

Suggested Citation

Velez-Pareja, Ignacio, Risky Tax Shields and Risky Debt: A Monte Carlo Approach (August 8, 2010). Available at SSRN: https://ssrn.com/abstract=1630056 or http://dx.doi.org/10.2139/ssrn.1630056

Ignacio Velez-Pareja (Contact Author)

Grupo Consultor CAV Capital Advisory & Valuation ( email )

Ave Miramar # 18-93 Apt 6A
Cartagena
Colombia
+573112333074 (Phone)

HOME PAGE: http://cashflow88.com/decisiones/decisiones.html

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