Comments on 'a Reconsideration of Tax Shield Valuation'

Abstract

Although Arzac and Glosten (2005) affirm that the value of tax shields depends upon the nature of the equity stochastic process, which, in turn depends upon the free cash flow process, I prove that the value of tax shields depends only upon the nature of the stochastic process of the net increase of debt. Arzac and Glosten (2005) formulate the constant leverage ratio assumption as Dt = L Et. The assumption of Fernandez (2004) is E{Dt}= L E{Et}, being E{bullet} the expected value operator, D the value of debt, E the equity value, and L a constant. Arzac and Glosten (2005) assumption requires continuous debt rebalancing, while mine does not. Under both financial policies, the expected leverage ratio is constant, but the Arzac and Glosten (2005) assumption is too extreme.

Keywords: Value of tax shields, APV, required return to equity, cost of capital, net increase of debt

JEL Classification: G12, G13, G31, G32, G33