Each of the three approaches discussed so far assumes that the present value of a dollar of tax saved by the company is fully reflected in shareholder value. But, in addition to arguments about the validity of each of these methods, there is also some disagreement as to whether the tax rate that should be used in calculating the value of the debt tax shield should be lower than the corporate tax rate because of taxes incurred by investors. The standard way to deal with this issue has been to define a net tax saving variable, T*, that reflects the tax treatment of the investors who hold the company’s debt and equity as follows:
(1-T*) = (1-TC)[(1-TPE)/(1-TPD)], (4)
where TPE is the marginal tax rate of the investors who determine the company’s cost of equity, and TPD is the tax rate at the margin of the investors who determine the company’s cost of debt.
As can be seen from this equation, if the tax treatment of debt and equity is the same, then the net tax saving variable, T*, is equal to the full corporate tax rate, and all the valuation formulas discussed above apply. But if the tax treatment of equity is more favorable than the tax treatment of debt, then T* will be lower than the full corporate tax rate and the valuation formulas should be adjusted accordingly. Specifically, the value of the debt tax shield should be calculated using the lower net tax saving rate, rather than the full corporate tax rate. For instance, in that case equation (2) should be:
PVTS = T*D, (5)
which yields a lower value for the debt tax shield. A value of T* lower than the corporate tax rate would also affect the calculation of the cost of capital, which we discuss below. This completes our brief review of the theory. We now summarize several debates among researchers that are relevant to the practical valuation of debt tax shields. These concern the size of the net tax saving, T*, and what formulas to use when valuing the debt tax shield.
Should you use APV, WACC, or capital cash flow?
The choice between the three methods of incorporating the debt tax shield into a valuation appears at first sight to be important. In one sense it is, because the three methods can give very different values. Nevertheless, they are entirely consistent with one another when the assumptions that each method makes about the company’s tax status and future leverage policy are met. Table 1 summarizes these assumptions and indicates (with an √) which method is likely to work best given a particular set of assumptions, and which methods (marked with X) are inconsistent with the particular assumptions.
The table shows that APV can always be used provided it is applied consistently. However, there are two cases where it clearly makes sense to use the other methods. One is when the company can be assumed to use a constant proportion of leverage. In that case, the WACC method is the simplest. The other is where the future tax saving is risky because, for example, the company may...