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Equivalence of the Different Discounted Cash Flow Valuation Methods: Different Alternatives for Determining the Discounted Value of Tax Shields and Their Implications for the Valuation

23 Pages Posted: 9 Jan 2000 Last revised: 16 Oct 2008

Pablo Fernandez

University of Navarra - IESE Business School

Date Written: October 8, 2007

Abstract

This paper addresses the valuation of firms by cash flow discounting.

The first part shows that the four most commonly used discounted cash flow valuation methods (free cash flow discounted at the WACC; cash flow for equityholders discounted at the required return to equity; capital cash flow discounted at the WACC before taxes; and Adjusted Present Value) always give the same value. This result is logical because all the methods analyse the same reality under the same hypotheses; they only differ in the flows used as the starting point for the valuation.

The disagreements in the various theories on the valuation of the firm arise from the calculation of the value of tax shields (VTS). The paper shows and analyses 7 different theories on the calculation of the VTS: Modigliani and Miller (1963), Myers (1974), Miller (1977), Miles and Ezzell (1980), Harris and Pringle (1985), Ruback (1995), Damodaran (1994), and Practitioners method.

When analysing the results given by the different theories, it should be remembered that the DVTS is not actually the present value of the tax saving due to the payment of interested discounted at a certain rate but the difference between two present values: the present value of the taxes paid by the firm with no debt minus the present value of the taxes paid by the company with debt. The risk of the taxes paid by the company with no debt is less than the risk of the taxes paid by the company with debt.

The paper also shows the changes that take place in the valuation formulas when the debt's market value does not match its book value.

Keywords: valuation methods, WACC, cash flow discounting, Adjusted Present Value

JEL Classification: G12, G31, M21

Suggested Citation

Fernandez, Pablo, Equivalence of the Different Discounted Cash Flow Valuation Methods: Different Alternatives for Determining the Discounted Value of Tax Shields and Their Implications for the Valuation (October 8, 2007). EFMA 2001 Lugano Meetings. Available at SSRN: https://ssrn.com/abstract=182308 or http://dx.doi.org/10.2139/ssrn.182308

Pablo Fernandez (Contact Author)

University of Navarra - IESE Business School ( email )

Camino del Cerro del Aguila 3
28023 Madrid
Spain
+34 91 357 0809 (Phone)
+34 91 357 2913 (Fax)

HOME PAGE: http://web.iese.edu/PabloFernandez/

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