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A Reconsideration of Tax Shield Valuation

9 Pages Posted: 29 Oct 2005  

Enrique R. Arzac

Columbia Business School - Finance and Economics

Lawrence R. Glosten

Columbia Business School - Finance and Economics

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Abstract

A quarter-century ago, Miles and Ezzell (1980) solved the valuation problem of a firm that follows a constant leverage ratio L = D/S. However, to this day, the proper discounting of free cash flows and the computation of WACC are often misunderstood by scholars and practitioners alike. For example, it is common for textbooks and fairness opinions to discount free cash flows at WACC with beta input Bs = [1 + (1-t)L]Bu, although the latter is not consistent with the assumption of constant leverage. This confusion extends to the valuation of tax shields and the proper implementation of adjusted present value procedures. In this paper, we derive a general result on the value of tax shields, obtain the correct value of tax shields for perpetuities, and state the correct valuation formulas for arbitrary cash flows under a constant leverage financial policy.

Suggested Citation

Arzac, Enrique R. and Glosten, Lawrence R., A Reconsideration of Tax Shield Valuation. European Financial Management, Vol. 11, No. 4, pp. 453-461, September 2005. Available at SSRN: https://ssrn.com/abstract=801906

Enrique R. Arzac (Contact Author)

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Lawrence R. Glosten

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

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