Value of Tax Shields (VTS): 3 Theories with 'Some' Sense

11 Pages Posted: 15 Jan 2015 Last revised: 29 May 2019

See all articles by Pablo Fernandez

Pablo Fernandez

University of Navarra - IESE Business School

Date Written: May 24, 2019


The value of tax shields (VTS) defines the increase in the company’s value as a result of the tax saving obtained by the payment of interest. However, there is no consensus in the existing literature regarding the correct way to compute the VTS. Most authors think of calculating the VTS in terms of the appropriate present value of the tax savings due to interest payments on debt, but Modigliani and Miller (MM) propose discounting the tax savings at the risk-free rate (RF), and Miles and Ezzell (ME) and many others propose discounting these tax savings the first year at the cost of debt and the following years at Ku.

We develop valuation formulae for companies that maintain a fixed book-value leverage ratio and argue that, for most companies, and especially when calculating residual values, this assumption is more realistic than those of MM and ME. We obtain an intermediate value between those of MM and ME.

If a company targets its leverage in market-value terms, it has less value than if it targets the leverage in book-value terms. How could a manager target leverage in market-value terms? However, many authors identify constant leverage with a constant market leverage ratio.

Keywords: value of tax shields, VTS, required return to equity, WACC, company valuation, APV, cost of equity

JEL Classification: G12; G31; G32

Suggested Citation

Fernandez, Pablo, Value of Tax Shields (VTS): 3 Theories with 'Some' Sense (May 24, 2019). Available at SSRN: or

Pablo Fernandez (Contact Author)

University of Navarra - IESE Business School ( email )

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


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