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 de...
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...pany is expected to experience constant growth and leverage, equation (8) is likely to provide the most reliable result. The size of the discrepancy from using inconsistent assumptions shows the importance of understanding the assumptions about debt policy that underlie the various methods of valuing debt tax shields and using them in a consistent way.
This has led to further debate about whether there is a leverage policy for a growing company that can give a value for the debt tax shield much larger than given by our formula. As yet, no one has come up with a convincing result, but the work is ongoing.
Works Cited
1) Pablo Fernandez “The Value of Tax Shields
Is NOT Equal to the Present Value of Tax Shields," Journal of Financial Economics, 2004
2) Cooper, Ian and Kjell G. Nyborg. 2007. Valuing the debt tax shield. Journal of Applied
Corporate Finance
In SIVMED’s case, based on the definition of WACC, all capital bases should be included in its WACC. These include its common stock, preferred stock, bonds and long-term borrowings. In addition to being able to compute for the costs of capital, the WACC also determines how much interest SIVMED has to pay for all its activities. The value of the firm’s stock, which we want to maximize, depends of the after-tax cash flow. Hence, after-tax values for WACC are also needed. Furthermore, cost of capital is used to determine the cost of each debt, stock or common equity. Being able to analyze these will be essential into deciding what and how new capital should be acquired. Hence, the present marginal costs are ideally more essential than historical costs.
In assessing Du Pont’s capital structure after the Conoco merger that significantly increased the company’s debt to equity ratio, an analyst must look at all benefits and drawbacks of a high debt ratio. The main reason why Du Pont ended up with a high debt to equity ratio after acquiring Conoco was due to the timing and price at which they bought Conoco. Du Pont ended up buying the firm at its peak, just before coal and oil prices started to fall and at a time when economic recession hurt the chemical industry of Du Pont. The additional response from analysts and Du Pont stockholders also forced Du Pont to think twice about their new expansion. The thought of bringing the debt ratio back to 25% was brought on by the fact that the company saw that high levels of capital spending were vital to the success of the firm and that high debt levels may put them at higher risk for defaulting.
...e overall performance of the company given that the higher the margin, the more likely that the company will retain a profit after taxes have been withdrawn. It is calculated by subtracting the cost of interest from the earnings before income taxes.
Discounted Cash Flow Method takes the forecast free cash flows during forecasted horizon. Then we estimate the cost of capital (weighted average cost of capital) and estimate continuing value (value after forecast horizon). The future value is discounted to the present value. We than add back cash ($13 Million) and non-current assets and deduct total debt. With the information provided several assumptions had to be made to obtain reasonable values (life period of 30-years, Capital expenditures not to exceed $1 million dollars, depreciation to stay constant at $1.15 Million and a discounted rate of 10%). Based on our analysis, the company has a stand-alone value of $51 Million at the end of fiscal year end 1990 with a net present value of cash flows of $33 million that does not include the cash and non-current assets a cash of and non-current assets.
If the interest income from these rates makes up approximately 35% of each company’s net
2. Given the forecasts provided in the case, estimate the expected incremental free cash flows associated with Du Pont’s growth strategy and maintain strategy for the TiO2 market. How much risk and uncertainty surround these future cash flows? Which strategy looks most attractive (i.e., using the DCF (e.g., NPV) method)??
Rousmaniere, Peter. “Facing a tough situation.” Risk & Insurance 17.7 (June 2006): 24-25. Expanded Academic ASAP. Web. 23 March 2011.
In “Preferred Shares” alternative, a local investment fund will invest $3.5 million preferred shares with a coupon rate of 7%, which will add interest expense by $245,000 annually as well as a leverage of 50% of the firm’s ownership if Globals are unable to pay dividends for two consecutive years. Total outstanding will come to 1,500,000 shares, making weighted average shares of 1,250,000. Net income will be brought to $330,750 and EPS will come up to
Having a low P/E ratio with respect to the rest of the market, and the replacement cost of the firm being greater than its book value (argument 3), there is a good chance that the current stock price and the proposed offering price are too low. Although long-term debt is a better financing choice, a few of the drawbacks are pointed out. Debt holders claim profit before equity. holders, so the chances that profits may be lower than expected. increases risk to equity, may reduce or impede stock value. However, the snares are still a bit snare.
Dhaliwal, D.S., Newberry, K.J., Weaver, C.D. Corporate Taxes and Financing Methods for Taxable Acquisitions, Contemporary Accounting Research. 22 (1), Spring 2005.
When starting a business an important question arises, how to finance the company. The steady economic growth combined with low interest rates has produced a lot of liquidity in debt and equity markets. For example, in 2005, non-financial corporate business borrowing increased dramatically to $289 billion, compared to the mere $174 billion it was in 2004 and the $85 billion it was in 2003 (Chung). The outcome of using only debt financing or only equity financing is mostly direct. Businesses run ino the issue when a company’s finance requires both debt and equity characteristics, changing the tax effects greatly (Hanke).
Brealey, Richard A., Marcus, Alan J., Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2nd edn, Craig S. Beytien, USA.
The final model used to compute the cost of capital was the earning capitalization model. The problem with this model is that it does not take into consideration the growth of the company. Therefore we chose to reject this calculation. The earnings capitalization model calculations were found this way:
Do not use coupon rate on firm’s existing debt as pre tax cost of debt