Scandinavian Working Papers in Economics

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

No 2007/15: Valuing the Debt Tax Shield

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: The tax shield from debt represents a significant proportion of total value for many companies, projects, and transactions. 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 increased practical importance of accurate valuation of the debt tax shield has been paralleled by debates among researchers about how to do it. The different approaches have large effects on estimated values. In this article, we review these approaches and show their implications for practical debt tax shield valuation. The issue we stress is that each method relies on a few basic assumptions, primarily about the risk of debt tax shields. Picking the most appropriate assumption in any particular situation and then using only those procedures that are consistent with that assumption is the key to good valuation of debt tax shields. Using inconsistent procedures can lead to large errors. The structure of the article is as follows: We start by giving a brief overview of the theory. Then we review the tensions that exist in the “how to value tax shields” literature. Next, we discuss the practical implications of the various approaches and show by way of an example the large errors that can arise if incorrect and inconsistent valuation methods are used. Finally, we offer our views as to which methods and assumptions are most appropriate in various real world economic settings.

Keywords: Tax Shields; Valuation; Risk

JEL-codes: G00

27 pages, March 27, 2007

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