Working Paper: CEPR ID: DP5182
Authors: Ian Cooper; Kjell G. Nyborg
Abstract: In a recent paper, Fernandez (2004a) 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, it 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-Ezzell and Miller-Modigliani leverage policies.
Keywords: Adjusted Present Value; Leverage; Tax Shields
JEL Codes: G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| leverage policy adopted (G32) | valuation of tax savings from debt (G32) |
| value of tax saving from debt (VTS) (H25) | present value of tax savings from interest (H25) |
| Fernandez's approach (B51) | overestimation of value of tax savings (H25) |
| inserting a valid identity from Modigliani-Miller framework (G19) | distortion of valuation outcomes (D46) |
| chosen leverage policy (E63) | resulting valuation of tax savings (H25) |