The Correct Value of Tax Shields

Abstract

For constant growth companies, we prove that the value of tax shields in a world with no leverage cost is the present value of the debt, times the tax rate, times the required return to the unlevered equity, discounted at the unlevered cost of equity. Please note that this does not mean that the appropriate discount for tax shields is the unlevered cost of equity, since the amount being discounted is higher than the tax shield (it is multiplied by the unlevered cost of equity and not the cost of debt). Rather, this result arises as the difference of two present values.

We also show that the value of tax shields is the difference between the present values of two different cash flows with their own risk: the present value of taxes for the unlevered company and the present value of taxes for the levered company. This is the difference between the present values of two separate cash flows each with its own risk.

Keywords: value of tax shields, required return to equity, leverage cost, unlevered beta, levered beta

JEL Classification: G12, G31, M21, H25