Corporate Valuation: The Combined Impact of Growth and the Tax Shield of Debt on the Cost of Capital and Systematic Risk

Journal of Applied Finance, Vol. 12, No. 2, Fall/Winter 2002

Posted: 24 Jun 2003

See all articles by Michael Ehrhardt

Michael Ehrhardt

University of Tennessee, Knoxville - Department of Finance

Phillip R. Daves

University of Tennessee, Knoxville - Department of Finance

Abstract

Valuation theory does not specify the combined impact of both growth and the tax shield of debt on the cost of capital, the cost of equity, and systematic risk. This paper fills that gap in the literature. Our results demonstrate that the widely used M&M models are inappropriate for a firm with non-zero growth and produce economically significant errors when used to estimate the cost of capital, the cost of equity, and systematic risk.

We show that discounting the debt tax shields of a firm with non-zero growth at a rate lower than the unlevered cost of equity yields two implausible results. First, the levered cost of equity can actually be lower than the unlevered cost of equity. Second, the levered cost of capital drops as growth increases, implying that high-growth firms should have large amounts of debt in their capital structures. Since these two results are inconsistent with intuition and corporate practices, we conclude that debt tax shields should be discounted at the unlevered cost of equity.

JEL Classification: G31, G32, G12

Suggested Citation

Ehrhardt, Michael and Daves, Phillip R., Corporate Valuation: The Combined Impact of Growth and the Tax Shield of Debt on the Cost of Capital and Systematic Risk. Journal of Applied Finance, Vol. 12, No. 2, Fall/Winter 2002, Available at SSRN: https://ssrn.com/abstract=360380

Michael Ehrhardt (Contact Author)

University of Tennessee, Knoxville - Department of Finance ( email )

Knoxville, TN 37996
United States

Phillip R. Daves

University of Tennessee, Knoxville - Department of Finance ( email )

Knoxville, TN 37996
United States

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