Corrections and Additions to 'the Value of Tax Shields is Not Equal to the Present Value of Tax Shields'
12 Pages Posted: 19 May 2005
Date Written: August 2004
In a forthcoming paper, Fernandez (2004) claims "the value of tax shields is not equal to the present value of tax shields". He values them by discounting the taxes paid by a levered firm and separately discounting the taxes paid by an unlevered firm. In contrast this paper considers tax shields as a derivative asset based on the value of an unlevered firm. It presents a self-financing dynamic portfolio strategy that replicates the tax shields from proportional debt policies. The unique value of tax shields is simply the cost of replicating the different taxes paid by a levered firm and an unlevered firm. This arbitrage-free value is different from the discounted value of Fernandez (2004).
In addition to valuation, the arbitrage approach extends the Modigliani-Miller (1963) and Hamada (1972) propositions to the case of proportional debt policy with risky debt. It also extends the Miles and Ezzel (1980) weighted average cost of capital formula to risky debt.
JEL Classification: G12, G31, G34
Suggested Citation: Suggested Citation