Analysis of The Tax Treatment of Investors

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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

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