Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2005/14: The value of tax shields IS equal to the present value of tax shields

Ian A. Cooper () and Kjell G. Nyborg ()
Additional contact information
Ian A. Cooper: London Business School, Postal: London Business School, Regent's Park, London , NW1 4SA, United Kingdom
Kjell G. Nyborg: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway

Abstract: Fernandez (2004b) 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.

Keywords: Value of tax shields; Leverage policy; Adjusted present value; Unlevered beta; Cost of capital

JEL-codes: G12; G31; G32

16 pages, December 22, 2005

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