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

See all articles by Steven L. Heston

Steven L. Heston

University of Maryland - Department of Finance

Date Written: August 2004

Abstract

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

Heston, Steven L., Corrections and Additions to 'the Value of Tax Shields is Not Equal to the Present Value of Tax Shields' (August 2004). Available at SSRN: https://ssrn.com/abstract=725121 or http://dx.doi.org/10.2139/ssrn.725121

Steven L. Heston (Contact Author)

University of Maryland - Department of Finance ( email )

Robert H. Smith School of Business
Van Munching Hall
College Park, MD 20742
United States

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