Motivation and background
Decisions about optimizing the capital structure of the firm, no matter if it is a small business or a global corporation, has always been an important issue for the management.
Various authors, (e.g. Booth (2002), Cooper and Nyborg (2006), Farber, Gillet and Szafarz (2006)) state that debt policy may only be viewed in terms of maintaining a fixed market value debt ratio (Miles-Ezzell assumption) or a fixed dollar amount of debt (Modigliani-Miller assumption).
The presence of debt financing increases the total cash flow available to debt and equity claimants, as the tax system in most countries allows interest costs to be tax deductible. As a consequence, a levered firm pays less in taxes than does a pure-equity firm, and the sum of the debt plus the equity of the levered firm must be greater than the sole equity of the unlevered firm. The value of the tax shield of debt has gained considerable attention in recent years in real world applications as well as in the academic literature.
The tax shield from debt represents a significant proportion of total value for many companies, projects, and transactions. Its potential size can be seen by considering a company with a 30% debt-to-capital ratio and a corporate tax rate of 40%. One approach to valuing the debt tax shield is simply to multiply the amount of debt by the tax rate, in which case the debt tax shield would be seen as contributing 12% of total value (Cooper, Nyborg 2007). And if the leverage ratio were doubled, the debt tax shield could be shown to contribute almost a quarter of the value of the company. Accurate valuation of the debt tax shield is of more importance than ever as leverage is now commonly used as a source of value added, and there is growing competition in buying assets. Changes in tax rules and more international transactions also make it important to understand how to value debt tax shields under different tax regimes.
The problem addressed in this work can be defined as following: how to correctly calculate the value of the tax shield of debt? The subsequent questions that will help to find the answer for the main problem are the following: what are the factors that have an impact on the present value of tax shields? What valuation model should be used for deriving the value of tax shield?
It is important to notice that this project work does not have an aim to reveal what is the optimal capital structure of the firm that will maximize the value of tax shield (that is discussed to a great extent by many researchers), the focus lies more on the finding the correct valuation method of benefits from taxes.
Structure of the work
In the following paper I am going to provide theoretical review on the subsequent master thesis work, focusing attention on the theoretical background for capital structure, focusing attention on tax savings from debt and particularly how to value correctly tax shields. In the first part...