Adjustment of the Wacc with Subsidized Debt in the Presence of Corporate Taxes: The N-Period Case

Estudios de Administración, Vol. 12, No. 2, pp. 45-66, 2005

16 Pages Posted: 31 Mar 2005 Last revised: 1 Apr 2009

See all articles by Ignacio Velez-Pareja

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation

Joseph Tham

Duke University - Duke Center for International Development in the Sanford School of Public Policy; Academy of Public Administration under the President of the Republic of Kazakhstan

Viviana Fernandez

Adolfo Ibanez University

Date Written: March 17, 2005

Abstract

In the standard Weighted Average Cost of Capital (WACC) applied to the free cash flow (FCF), we assume that the cost of debt is the market, unsubsidized rate. With debt at the market rate and perfect capital markets, debt only creates value in the presence of taxes through the tax shield. In some cases, the firm may be able to obtain a loan at a rate that is below the market rate. In a previous work, we showed how to adjust the WACC in the presence of a subsidy and no taxes. There, we showed that plugging the lower (subsidized) cost of debt into the WACC formula is not the correct approach to measuring the value creation due to the subsidy. With subsidized debt and taxes, there would be a benefit to debt financing, and the unleveraged and leveraged values of the cash flows would be unequal. The benefit of lower tax savings are offset by the benefit of the subsidy. These two benefits have to be introduced explicitly. How would we adjust the WACC to take account of the subsidized debt? And how would we adjust the expression for the required return to leveraged equity?

In this paper, using a multiple period example we present the adjustments to the WACC with subsidized debt and taxes. We demonstrate the analysis for both the WACC applied to the FCF and the WACC applied to the capital cash flow (CCF). We use the calculation of the Adjusted Present Value, APV, to consider both, the tax savings and the subsidy. We show how all the methods match.

Keywords: Adjusted Present Value, APV, weighted average cost of capital, discounted cash flow, DCF equity value, cost of equity, WACC, subsidized debt with taxes, valuation of cash flows, project evaluation, project appraisal, firm valuation, cost of capital, cash flows, free cash flow, capital cash flow

JEL Classification: D61, G30, G31, G32, H43

Suggested Citation

Velez-Pareja, Ignacio and Tham, Joseph and Fernandez, Viviana, Adjustment of the Wacc with Subsidized Debt in the Presence of Corporate Taxes: The N-Period Case (March 17, 2005). Estudios de Administración, Vol. 12, No. 2, pp. 45-66, 2005. Available at SSRN: https://ssrn.com/abstract=688363

Ignacio Velez-Pareja (Contact Author)

Grupo Consultor CAV Capital Advisory & Valuation ( email )

Ave Miramar # 18-93 Apt 6A
Cartagena
Colombia
+573112333074 (Phone)

HOME PAGE: http://cashflow88.com/decisiones/decisiones.html

Joseph Tham

Duke University - Duke Center for International Development in the Sanford School of Public Policy ( email )

Box 90312
302, Towerview Dr, Rubenstein Hall, Room 272
Durham, NC 27708
United States
919-613-9234 (Phone)
919-681-0831 (Fax)

HOME PAGE: http://fds.duke.edu/db/Sanford/faculty/thamjx

Academy of Public Administration under the President of the Republic of Kazakhstan ( email )

Abay Street, 33a
Astana
Kazakhstan
+7 8 7172753422 (Phone)

Viviana Fernandez

Adolfo Ibanez University ( email )

Diagonal Las Torres 2640
Peñalolen
Santiago, 794-1169
Chile

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