The value of tax shields IS equal to the present value of tax shields

Fernandez [2004b. The value of tax shields is not equal to the present value of tax shields. Journal of Financial Economics 73, 145–165] argues that the present value effect of the tax saving on debt cannot be calculated as simply the present value of the tax shields associated with interest. This contradicts standard results in the literature. It implies that, even though the capital market is complete, value-additivity is violated. As a consequence, adjusted present value formulae of a standard sort cannot be used. Also, Fernandez's argument implies that the value of the tax saving differs from conventional estimates by a considerable amount. We reconcile Fernandez's results with standard valuation formulae for the tax saving from debt. We show that, as one would expect, the value of the debt tax saving is the present value of the tax savings from interest. The apparent violation of value-additivity in the Fernandez paper comes from mixing the Miles and Ezzell and Miller and Modigliani leverage policies.     

Have the tax benefits of debt been overestimated?

We re-examine the claim that many corporations are underleveraged in that they fail to take full advantage of debt tax shields. We show prior results suggesting underleverage stems from biased estimates of tax benefits from interest deductions. We develop improved estimates of marginal tax rates using a non-parametric procedure that produces more accurate estimates of the distribution of future taxable income. We show that additional debt would provide firms with much smaller tax benefits than previously thought, and when expected distress costs and difficult-to-measure non-debt tax shields are also considered, it appears plausible that most firms have tax-efficient capital structures.     

Corporate taxes,strategic default,and the cost of debt

The current US tax code’s loss carry provisions provide implicit tax subsidies to financially troubled firms. Since shareholders ultimately decide when to announce bankruptcy, such tax subsidies can incentivize them to strategically postpone default. Therefore, corporate taxation can influence corporate cost of debt. Using a large panel of corporate bonds, we find supporting evidence: credit spreads become smaller as tax loss carries grow larger. In contrast, tax shields such as depreciation, which limit loss carry gains, lead to wider spreads. Interestingly, when stockholders hold greater bargaining power – due to large managerial ownership – larger corporate tax shields lead to even narrower credit spreads.     

A Reconsideration of Tax Shield Valuation

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 β _S = [1 + (1 ? τ)L]β_u, 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.     

EVIDENCE ON THE ROLE OF TAXES ON FINANCING CHOICE: CONSIDERATION OF MANDATORILY REDEEMABLE PREFERRED STOCK

In this study we examine the effect of firms' marginal tax rates on incremental and overall reliance on mandatorily redeemable preferred stock (MRPS). Similarities in the cash flows associated with debt and MRPS, as well as similarities in the claims of holders of debt and MRPS on the assets of issuing firms, suggest that MRPS may be viewed as a substitute for debt. However, important differences in the tax treatment of MRPS and debt suggest that firms that cannot make full use of interest tax shields may be able to finance more efficiently using MRPS instead of debt. The results indicate that, both incrementally and overall, firms with low marginal tax rates rely more heavily on MRPS than debt relative to firms with high tax rates. This finding is consistent with the proposition that firms that cannot make full use of interest tax shields finance incrementally using equity rather than debt.     

The Effect of Taxes and Depreciation on Corporate Investment and Financial Leverage

This paper provides an analysis of the effect of corporate and personal taxes on the firm's optimal investment and financing decisions under uncertainty. It extends the DeAngelo and Masulis capital structure model by endogenizing the firm's investment decision. The authors' results indicate that, when investment is allowed to adjust optimally, the existing predictions about the relationship between investment-related and debt-related tax shields must be modified. In particular, the authors show that increases in investment-related tax shields due to changes in the corporate tax code are not necessarily associated with reductions in leverage at the individual firm level. In cross-sectional analysis, firms with higher investment-related tax shields (normalized by expected earnings) need not have lower debt-related tax shields (normalized by expected earnings) unless all firms utilize the same production technology. Differences in production technologies across firms may thus explain why the empirical results of recent cross-sectional studies have not conformed to the predictions of DeAngelo and Masulis.     

On the Equivalence between the APV and the wacc Approach in a Growing Leveraged Firm

While in a steady state framework the choice between the wacc approach ( Modigliani‐Miller, 1963 ) and the adjusted present value (APV) approach ( Myers, 1974 ) is irrelevant since the two approaches provide the same result, however, in a growing firm context the wacc equation seems to be inconsistent with the APV result. In this paper we propose a simple model to evaluate the tax savings in a growing firm in order to show under which assumptions the two approaches lead to the same results. We demonstrate that the use of the wacc model in a steady‐growth scenario gives rise to some unusual assumptions with regard to the discount rates to be used in calculating tax shields. We show that the widely used wacc formula, if used, as it is in most cases, in a growth context, implies that a) debt tax shield related to already existing debt are discounted using k_d; b) debt tax shield related to new debt, due to company's growth, are discounted, according to a mixed procedure, using both k_u and k_d. We discuss the inconsistency of such a discounting procedure and the preferred features of the APV approach.     

DOES FINANCIAL FLEXIBILITY REDUCE INVESTMENT DISTORTIONS?

The average U.S. firm has less leverage than one would expect based on the trade‐off between tax shields and bankruptcy costs. We focus on firms’ financial flexibility and examine whether firms preserve debt capacity to reduce investment distortions in the future. We find that firms with high unused debt capacity invest more in future years than do firms with low unused debt capacity. Furthermore, firms that are reluctant to borrow in unconstrained periods are more likely to issue debt in periods in which access to capital markets is more constrained.     

Interest Tax Shields: A Barrier Options Approach

There is a link between barrier options and tax shields of interest expense. We combine this link with a traditional valuation approach, to present practical valuation formulas for interest tax shields in three debt scenarios with risk of default: (1) constant debt, (2) delayed debt, and (3) debt refinancing. In all cases, default and refinancing are contingent on the random evolution of the income of the firm. For each scenario, we work out sensitivity analysis of the value of tax shields with respect to income, growth, systematic and business risk, risk-free interest rate, interest coverage ratio covenant, and the firm??s refinancing strategy.     

Dividend distributions and closed-end fund discounts

Empirical support for the hypothesis that closed-end fund discounts are related to overhanging tax liabilities has been mixed. We introduce a new approach to testing this hypothesis by examining changes in discount levels following distributions of dividends and capital gains. Since distributions reduce future shareholder tax liabilities, the tax liability hypothesis implies that closed-end fund discounts should decline following distributions. Focusing on changes in discounts isolates this tax effect by eliminating the impact of other fund-specific factors on discount levels. Our results support the tax liability hypothesis, showing that short-run fluctuations in discounts are directly affected by taxable distributions.     

Debt Tax Shields Around the OECD World

Taxes affect a company’s optimal capital structure, value, and cost of capital, but their impact depends on the tax regime of the country where the company operates. The OECD classifies the tax regimes of its member countries in seven groups. In this paper we offer a general model that encompasses those seven groups. We show that tax benefits of debt vary significantly across tax systems, and that using either Modigliani and Miller’s (1963) or Miller’s (1977) formulas in other tax regimes can lead to quantitatively important mistakes. We also find a significantly positive relationship between average leverage in OECD countries and our indicator of tax shields.     

Determinants of debt: Empirical evidence on firms in the district of Santarém in Portugal

In recent decades, the theme of the capital structure and its determinants has caused some controversy and aroused great interest in the financial domain. Several theories and studies have emerged applying to this domain. This study aims to test the explanatory power of the determinants of debt which have the greatest support in the financial literature, size, growth, business risk, profitability, tangibility and non-debt tax shields and its validity in accordance with the theories of capital structure, on firms in Santarém's district. The sample contains financial data of 6184 firms for the period 2008–2012. The results indicate that firms in Santarém's district in Portugal have a high level of debt, using mainly short-term debt. The growth and profitability have proved to be determinants of debt, confirming the Pecking Order Theory.     

Unanticipated inflation and the value of the firm

Evidence presented here indicates that the relationship between stock returns and unexpected inflation differs systematically across firms. The differences are shown to be consistent with cross-sectional variation in firms' nominal contracts (monetary claims and depreciation tax shields). The differences are also partially explained by proxies for underlying firm characteristics that could create interaction between unexpected inflation and operating profitability. Finally, much if not most of the differences appear to arise because unexpected inflation is correlated with changes in expected aggregate real activity, the effects of which tend to vary across firms according to their systematic risk.     

Debt Financing and Tax Status: Tests of the Substitution Effect and the Tax Exhaustion Hypothesis Using Firms' Responses to the Economic Recovery Tax Act of 1981

This study tests the joint prediction of the substitution effect and the tax exhaustion hypothesis that an increase in non-debt tax shields leads to a decrease in leverage. Controls are introduced for the debt securability effect, the pecking order theory of financing, and the probability of losing tax shields. Using the relationship between changes in investment tax shields and changes in debt tax shields of firms in response to the Economic Recovery Tax Act of 1981, strong empirical support is found for predictions based on the substitution effect and the tax exhaustion hypothesis.     

Corporate Leverage and Nondebt Tax Shields: Evidence on Crowding-Out

A negative relationship between corporate leverage and tax shields has been predicted because a large nondebt tax shield reduces the expected value of interest tax savings and lessens the advantage of debt financing. Previous studies, however, have provided inconclusive and contradictory evidence on whether nondebt tax shields crowd-out debt financing. The analysis herein relies on unique constructs of discounted depreciation tax shields and presents evidence that crowding-out does not occur. Furthermore, it is shown that contradictory inferences may result from analysis of annual tax depreciation deductions instead of discounted tax shields. The findings suggest that firms with substantial cash flow from depreciation exploit their higher debt capacity by maintaining a capital structure with significantly more debt than otherwise.     

Back on the balance sheet: The tax effects of contingent claims in commercial banking

Contingent claims separate revenue and cost into two different time periods. Revenue comes in the initial origination process, while the cost comes upon completion of the contract in the event of default. With banks increasing contingent claims in recent years, a higher taxable income leads to a shift in a bank's balance sheet toward tax-free income and tax-shielding liabilities. This provides a valuable case-study of corporate finance theories of tax management. This paper builds a model to illustrate the income features of contingent claims. Call Reports from 1990-1996 are examined, and show significant evidence of increases in leverage associated with contingent claims.     

The effectiveness and valuation of political tax minimization

We find evidence suggesting that corporate lobbying for tax purposes over the period 1999–2009 is one method by which firms managed corporate taxes. Furthermore, tax management strategies employed by these politically active firms were valued by shareholders. Firms lobbying on tax issues have lower book effective taxes and greater discretionary permanent differences in GAAP and IRS taxable income. Investors place a premium on lobbying activities for tax purposes unless the firm already has a low effective tax rate or very high book-tax differences. We conclude that lobbying political officials is one method by which firms manage risks attendant an aggressive tax strategy.     

ESTIMATING THE TAX BENEFITS OF DEBT

The standard approach to valuing interest tax shields assumes that full tax benefits are realized on every dollar of interest deduction in every scenario. The approach presented in this paper takes account of the possibility that interest tax shields cannot be used in some scenarios, in part because of variations in the firm's profitability. Because of the dynamic nature of the tax code (e.g., tax-loss carrybacks and carryforwards), it is necessary to consider past and future taxable income when estimating today's effective marginal tax rate. The paper uses a series of numerical examples to show that (1) the incremental value of an extra dollar of interest deduction is equal to the marginal tax rate appropriate for that dollar ; and (2) a firm's effective marginal tax rate (and therefore the marginal benefit of incremental interest deductions) can actually decline as the firm takes on additional debt.
Based on marginal benefit functions for thousands of firms from 1980–1999, the author concludes that the tax benefits of debt averaged approximately 10% of firm value during the 1980s, while declining to around 8% in the 1990s. By taking maximum advantage of the interest tax shield, the average firm could have increased its value by approximately 15% over the 1980s and 1990s, suggesting that the consequences of being underlevered are significant. Surprisingly, many of the companies that appear best able to service debt (i.e., those with the lowest apparent costs of debt) use the least amount of debt, on average. Treasurers and CFOs should critically reevaluate their companies' debt policies and consider the benefits of additional leverage, even if taking on more debt causes their credit ratings to slip a notch.     

On the value and determinants of the interest tax shields

We use a dynamic model of the firm to ascertain both the value and the determinants of the debt tax shields. For a representative U.S. firm, we find that the value of the interest tax shields represents less than 5 % of firm value, and it varies considerably across U.S. industries. Our results also show that this component of firm value behaves counter-cyclically over the business cycle. Finally, besides the interest rate on debt and the corporate income tax rate, we find that the curvature of the production function is one of the main determinants of the tax advantage of debt.     

Do Taxes Affect Corporate Financing Decisions?

This paper provides clear evidence of substantial tax effects on the choice between issuing debt or equity; most studies fail to find significant effects. The relationship between tax shields and debt policy is clarified. Other papers miss the fact that most tax shields have a negligible effect on the marginal tax rate for most firms. New predictions are strongly supported by an empirical analysis; the method is to study incremental financing decisions using discrete choice analysis. Previous researchers examined debt/equity ratios, but tests based on incremental decisions should have greater power.