Topics in Cost of Capital Consistent Valuation and Cost of Capital Expressions With Corporate and . Personal Taxes Robert A. Taggart, Jr. Robert A. Taggar, Jr, is a Professor of Finance at the Wallace E. Carroll School of Management, Boston College, Chestnut Hill, Massachusetts. - The adjusted present value, adjusted discousit rate and flows to equity valuation methods represent three different approaches to valuing firms and other assets.1 Ifthey are tobe used interchangeably, all three methods should result in identical values for a given asset; achieving such consistency in practice can prove elusive for several reasons. First, each method incorporates the asset's business risk and the tax effects of its financing mixin a different way, and each relies on a different cost of capital mea- sure. It is thus necessary to understand how these mea- ‘Lam grateful to George Aragon, Ivan Brick, Robert Damimon, Alan ‘EDaskin, Douglas Emery, John Finnerty, Lawrence Fisher, Timothy ‘Mech, James Miles, George Pinches, Alexandros Prezas, Abraham ‘Ravid, Richard Ruback, Gordon Sick, Joseph Yagi, participants in the finance workshops at Boston University, the University of Dela- ‘wareand Rutgers Unversity andthree anonymous eviewersforhelp- falcomments on an carer draft. am, ofcourse, responsible for any remaining ero sures are related to one another. Second, the interrela~ tionships among different cost of capital measures are not unique. There are several distinct sets of valuation and cost of capital expressions, each derived under dif- fering assumptions about the asset's cash flow and financing pattern and the applicable tax regime. Con- sistent valuation, of course, requires cost of capital ex- pressions that are all based on the same assumptions. Finally, in many practical situations, it is cumbersome or even impossible to use all of the valuation methods. In such cases, they are not interchangeable, and the analyst should know which one is superior. The potential for confusion resulting from this array of techniques and assumptions is heightened by the "The adjusted discount rate method is also known asthe weighted average cost of capital, or WACC method [15], while the flows to ‘equity method is also known asthe equity residual income method [10] or the equity esidual value method [25]. Conyright © 2001. All Rights Reserved.‘TAGGART/CONSISTENT VALUATION fragmented approach to the topic in textbooks and the literature. The literature has dealt most extensively with the case in which financing affects value only through corporate taxes.? Three distinct sets of cost of capital expressions have been derived for thiscase,each resting on adifferent assumption about the riskiness of future debt tax shields. For the case that includes both corporate and personal taxes, however, a complete set of analogous expressions has yet to be derived, and dif- ferences in assumptions about the risk of debt tax shields have not received substantial emphasis.? The ‘purpose of this paper is to fill that gap. Section I describes the three valuation methods, and Section II surveys and summarizes existing results on valuation with corporate but no personal taxes. This includes two cases in which all future debt tax shields are known with certainty and two in which they are un- certain, Section III introduces personal taxes and derives cost of capital expressions for different assump- tions about the risk of future debt tax shields. Section 1Voffersrecommendations for choosingamongthe dif- ferent valuation approaches, and Section V sum- ‘marizes the principal findings. |. Three Valuation Methods Alll three basic valuation methods seek to discount after-corporate-tax cash flows at pre-investor-tax dis- ‘count rates, but they make different adjustments for the ‘effects of financing. Myers’ [22] adjusted present value (APV) method calls for first computing a base-case value under the assumption of 100% equity financing, and then separately adding the present values of any costs and benefits from the actual financing package. The base-case value is calculated by discounting the asset's expected after-corporate-tax operating cash flows, Cy, for each period n at an all-equity, or un- levered, discount rate, r4 The adjusted discount rate (ADR) method dis- counts expected operating cash flows, Cy, at arate that reflects the asset's financing combination. Both the APV and ADR methods thus discount the same cash flows. However, the APV method adjusts for financing in one or more separate discounted cash flow terms, 25ee [1 (10) 02 (4) (15 [8 [9 21 (2) and 30] for iscussions of this case. 3Bsisting results for this case canbe found in [4 {6} 8) {13} [16}, and pent expected sect owt company wu have gotten in period if it had been entirely equityfinanced, with no debt service charges deducted. while the ADR method does so entirely in the discount rate. inally, the flows to equity (FTE) method calculates cash flows to the ‘equityholders ata cost of equity capital. The cash flows areinturcalculatedby subtracting after-corporate-tax financing charges from the all-equity cash flows,C, and thus they represent actual cash flows to sharcholders. By contrast, the cash flows used under the other two ‘methods are hypothetical, all-equity cash flows. A limitation of the analysis, which should be noted at the outset, is that all debt is assumed free of default risk. This assumption is made in part to maintain com- parability with the bulk of the literature and in part to avoid unnecessary complexity. It does imply, however, that tax factors are the only effect of capital structure to be incorporated, while factors such as bankruptcy, agency and information costs are ignored.S I. Valuation With Corporate But No Personal Taxes The notation used throughout the paper is sum- marized in Exhibit 1. The valuation and cost of capital expressions that appear most frequently in textbooks and other finance literature include only the corporate taxeffects of debt, and these appear in Exhibit 2. There are six basic relationships: the APV relationship be- ‘tween total value and unlevered value; the overall cost of capital expressed as a weighted average of the cost of equity and the cost of debt; the overall cost of capital asafunction of the unleveredcost of capital; the levered ‘cost of equity as a function of the unlevered cost; the cost of equity as afunction of beta; and the levered beta asa function of the unlevered beta. These relationships can take on three different forms, as shown in the three panels of Exhibit 2, depending on what is assumed about the time pattern and risk of the firm's interest tax shields. A. The Case of Constant, Perpetual Debt The cost of capital expressions in Panel A of Exhibit 2are probably the most widely known (e.., [12], [21], Some of the consequences of risky debt have been analyzed in {7} {23}, [28] and [31] Inthe absence of bankruptcy costs, Sick 28] has obtained similar results to ths pape’, but it shouldbe emphasized that the cos of debt must then be interpreted as an expected, rather than a promised rate of return. It is incorrect to substitute the con- ‘actual debt rate for the risk-free rte. Similarly, under the APV approach, certanty-equvalent interest payments should be used in place of contractual interest payments. Conyright © 2001. All Rights Reserved.Exhibit 1. Summary of Notation E_ = market value of equity D_ = marketvalue of debt V = E+ D = total market value of firm rm = equilibrium expected return on market portfolio of equity securities cost of equity for an individual firm = cost of risk-free equity cost of risk-free debt unlevered, or all-equity, cost of capital = adjusted, or overall, cost of capital personal tax rate on income from bonds effective personal tax rate on income from equity cconporate tax rate -{:-E pay) vantage of corporate de Cy = expected value of period n after-corporate- tax operating cash flow, C,, beta, or systematic risk, of an unlevered firm beta of otherwise equivalent levered firm fective tax [27], [30)), and they have been shown to give consistent results under all three valuation methods ({1], [6], [10], [16}, (22]). Since they show explicitly the relationship between the cost ofcapital and leverage, they also afford the flexibility to determine the valuation effects of al- ternative financing plans. Unfortunately, as Myers [22] has pointed out, all of the relationships in Panel A hold simultaneously only under restrictive assumptions: the stream of expected operating cash flows must bea level perpetuity, and the firms outstanding debt (and hence its annual interest tax shicld) must be known and con- stant forever.® Thus, most of the expressions in Panel A, though frequently cited in textbooks and elsewhere, are really of rather limited usefulness in practical valua- tion situations. B. Finite Asset Lives with Known Debt ‘Schedules ‘Myers [22] has shown that the APV approach to valuation can be generalized to allow for finite and un- ‘This framework can also accommodate constant perpetual growth, asin Lewellen and Emery [16], but only level perpetities are con- ‘sidered hereto avoid excessive complication. FINANCIAL MANAGEMENT/AUTUMIN 1991 even operating cash flow streams. In particular, if the schedule of future debt levels is currently known with certainty, the value at time ¢ of an asset whose useful life ends at time NV is given by ta TeDnat » 6 8 TP ade However, while this provides a natural generalization of Equation (2A.1) in Exhibit 2, there are no finite-ife analogues for Equations (24.2), (2A.3), (2A) ot (2A5) that are generally valid when the schedule of outstanding debt is certain. Thus, it is not feasible to use either the adjusted discount rate or flows to equity ‘methods in this case.” C. The Miles-Ezzell Analysis Alternatively, one can argue that it may not make the best sense to assume that future debt levels are known. For example, Fama’s (9] analysis implies that one can justify the use of risk-adjusted discount rates to value a level perpetuity by assuming that each period’s expected operating cash flows follow a geometric random walk. In that event, however, firm value also follows a random walk, and it seems incon- jstent to assume that the level of debt remains constant with certainty even in the face of a changing firm value. In an attempt to address this inconsistency and at the same time derive adjusted discount rates that are valid for finite asset lives and uneven cash flow streams, Miles and Ezzell [18] started with the premise that the firm maintains a constant debt-to-value ratio. The cur- rent debt level, which is based on current firm value, is known, so in the absence of default risk the interest tax shield at the end of the first period is also certain, Thus, itis justifiable to discount the first period’s interest tax shield at ra, the risk-free debt rate. However, future firm values, and hence future debt levels, are currently uncertain. If the firm maintains a constant debt-to- value ratio, future firm value will be perfectly corre- lated with the value of the operating cash flow stream, and therefore all interest tax shields beyond the first period should be discounted at r the unlevered cost of capital. 7The CAPM can be used to compute a cost of equity forthe current period, given an accurate estimate of, but itis stil impossible to use the FTE method. Future debt levels are known, bu future firm value ‘and hence future leverage ae random. Thus future levels of ae also random, sothe appropriate cost of equity for valuing future cash lows ‘cannot be determined today. Conyright © 2001. All Rights Reserved.‘TAGGART/CONSISTENT VALUATION 1" wor Gd ef Exhibit 2. Summary of Valuation and Cost of Capital Expressions When There are Corporate But No Personal Taxes Panel A. Operating Cash Flow Stream is a Perpetual Annuit Adjusted Present Value ‘Weighted Average Cost of Capital ‘Overall and Unlevered Cost of Capital Cost of Equity and Unlevered Cost of Capital Cost of Equity and Beta Levered and Unlevered Beta Panel B. Finite or Perpetual Life; First Debt Tax Shield Certain, Others Uncertain (D’ a Ct Min 4 ma Te \P) er tO Fa vy (2B) te 6) +mai(1-T.) (?) (282) ~ maT. (#4) (7) Ba) po [-m (4% (=) F (234) re= 174 +B (tm — 13) (Bs) D 1+, Te A.=Bu(1+2) (+ b-x) @B5) s Future Debt Levels are Known With Certainty =f+Tp (At) ren 6) +a(1-Te) (?) (242) eo rf. “te (?)) (a3) n=rt(—m@(l-T)E (Aa) re= 19a +B (tm —r4d) @AS) Bb =po(i+0 -798) (26) Panel C. Finite or Perpetual Life: ‘All Debt Tax Shields Uncertain (p\ Ct tel) sn een te () +ra(1—T.) (7) ca) Per—meTe (?) ec) n=rt¢-mi)e cay re= 174+ Bm — 1d) @cs) A.=Bu ( + 3) ec) Based on this reasoning, Milesand Ezzel ({18},[19]) derived the set of valuation and cost of capital expres- sions in Panel B of Exhibit 2. Unlike those in Panel A, the Miles-Ezzell expressions give consistent results ‘under any of the three valuation methods for both per- petual and finite-lived assets. However, these results will generally differ from those derived from Panel A, even in the perpetuity case, because of their different assumption about the risk of debt tax shields. Conyright © 2001. All Rights Reserved.2 Another point that emerges from contrasting Panels Aand Bis the role of the weighted average cost of capi- tal, which can be used in either case. This is because the market's valuation of debt tax shields is captured in the cost of equity, .. Ifan estimated cost of equity correctly reflects investors’ assumptions about the risk of the debt tax shields, whatever those assumptions may be, the weighted average cost of capital will yield a valid adjusted discount rate. . The Harris-Pringle Analysis Harris and Pringle [14] have proposed that all debt tax shields, including the first year’s, be treated as risky and discounted at, which leads to the set of equations in Panel C of Exhibit 2. These can be thought of as the analogues of the Miles-Ezzell expressions when the firm adjusts its debt level continuously to the target ratio. For example, the Miles-Ezzell cost of capital ex- pression (2B.3) can be rearranged to produce: ltr era tee- nae ($82)(8) _ tn |i+ra (1-7) a TH ‘Then, dividing each period into arbitrarily small sub- periods, gives D, D seltu(I-TeP) -t = er-mle (3) Hence, expression (2C.3) is the continuous-time ver- sion of (2B3). ‘The relationships in Panel C have a simpler form than those in Panel B, and as a practical matter, they do not yield valuations that are very different, Like the Miles-Ezzellequations, they are applicable tofinite and ‘uneven cash flow streams as well as level perpetuities, and theywill give identical resultsunder any of the three valuation methods. As in the other two panels of Ex- hibit 2, the weighted average cost of capital isa valid overall cost of capital expression, but here it reflects FINANCIAL MANAGEMENT/AUTUMIN 1991 the relationship between re and r that is expressed in (C4). Ill. Valuation With Corporate and Personal Taxes Tn this section, we introduce personal taxes and derive valuation and cost of capital expressions analogous to those discussed in Section II. However, care must be taken in specifying investors’ required rates of return. While these are often analyzed on a pre- taxbasis, itis after-tax returns that ultimately drive the valuation process, and thus the equilibrium relation- ships among after-tax returns must be understood. In the remainder of this section, we assume that all inves- tors pay taxes on income from debt securities at the rate Tpandon income from equity securities at the rate Tpe® Forsimplicity, we also assume that ll investors are sub- ject to the same tax rates. ‘A. After-Tax Rate of Return Relationships In equilibrium, debt and equity securities of com- parable risk must offer identical after-tax returns, or else investors will be motivated to rearrange their portfolios. In particular, suppose we have a risk-free debt security offering a pre-tax return per period of ria and a risk-free equity security offering a pre-tax return per period ofr.9 These returns will be set in the market so that: dT) = 9AM “ More generally, a tax-adjusted capital asset pricing model (CAPM) can be derived (e.g, [5], [11]), charac- terizing the after-tax returns on securities of both dif- ferent risk and different tax treatment. Suppose, for ex- ample, that all risky assets are in the form of equity and that the expected pre-tax return to investors from this ‘market equity portfolio is rm. Ifre is the pre-tax return on firm,’s equity, then in equilibrium,!° "Asin Miller (20), Ty shouldbe interpreted as an effective tax rate, or as the uniform anual tax rate that would produce tax payments having the same present value asthe pattern of actual tax payments cn equity income. Sin a CAPM context can be thought of the pre-tax return on a zero-beta equity portfolio, Alternatively could be interpreted as the cost of equity for an entirely eqiy-Ananced firm with isles assets, For the analysis that follows itisnot necessary that a specifi, riskless equity security exist as long as one can be created symthet- Conyright © 2001. All Rights Reserved.‘TAGGART/CONSISTENT VALUATION 1b ~ Ty)~ted ~ Ty) =B, ltl —Toe)ed ~ Te» (9) where} the systematicrisk measure, Using Equation (4) this can be simplified to: ri =e * Bmp) () ‘The important point is that, in general, rates of return should be compared on an after-personal-tax basis, Pre-tax comparisons are’valid only if all rates apply to instruments that receive identical tax treat- ‘ment, Thus fm, which is taxed at the rate Tpe, is directly comparable with , asin Equation (6), but not with ri, which is taxed at the rate Tp. B, The Case of Constant, Perpetual Debt For the level perpetuity case with constant debt, Miller [20] has shown that Equation (3A.1) in Exhibit 3 holds, where Gy is the net tax benefit from corporate the basisfor the APV approach in this case. ‘The remaining equations in Panel A of Exhibit 3 ay moves from (3A.1) and from basic valuation definition ‘Two points are worth special note. First, one: from the equations in Panel A of Exhibit 2 to those in Panel A of Exhibit 3 by making two adjustments: (i) Te, the corporate tax rate, is replaced by Gz, the net tax advantage to corporate debt; (i) ry, the risk-free, rate, is replaced by rf, the risk-free equity rate: @tn- eed, it will be seen below that the same rule applies to ‘every equation in Exhibit 3. In particular, if the CAPM is to be used to estimate a cost of equity, consistency requires that it be an after-personal-tax CAPM, as em- bodied in Equation (3A.5). Second, the assumptions that the operating cash flow stream isa level perpetuity and that debt is known and constant forever imply that the equations in this panel, like those in Panel A of Exhibit 2, are of limited practical use. 2A relatively simple proof canbe constructed using the same steps in Rubinstein 27, but wth endo period investor wealthcal- afterall ts. pecifcally, Equation (3A.2) follows from the defi E=C~rD(l ~ T)/re and V= C/r. Equation (3A3) is ob- tained from equating 341) and V = Cir. Equation A.) flions {rom equating (34.2) and (34.3) and solving for Equation (34.6) follows from wring GAS) for levered and an wnlevered fm and equating GA) and (3A) forthe levered frm. "These two rules are also valid for the weighted average cost of capita @A2), although not writen in that form in Exhibit 3 That is because, from Equation () and the definition of Gy, nl ~G,) =A ~T)- C. Finite Asset Life With a Known Debt Schedule As in Section II, one way to obtain more broadly applicable valuation expressions is to retain the as- sumption that future debt levels are known but allow for finite and uneven cash flow streams. Beginning with the APV approach, it might seem natural to generalize the analysis of Section II by simply substituting Gy in place of 7. in Equation (1) above. However, that would bbe incorrect. The reason is that the debt tax shields in the second term of Equation (1) are cash flows to the equityholders and should be discounted at an equityholders’ opportunity cost. When there are only corporate taxes, investors would not distinguish be- tween risk-free debt and risk-free equity, so it is per- fectly appropriate to discount the second term in Equa- tion (1) at the bondholders’ opportunity cost, rj. But when there are both corporate and personal taxes that isno longer the case. Instead, asshown in the Appendix, the correct generalization of Equation (1) i Cog Sh GDant Su TFS C4 x y 2) Thus, not only must Gz, be substituted for T, in moving from Equation (1) to Equation (7), but also re ‘ust be substituted for 7 The second term in Equa- tion (7) might best be thought of as the present value ofan annual financing subsidy. Asin Brealey and Myers [4], the value of a subsidy can be calculated as the present value of the annual difference between unsub- sidized and subsidized debt service charges (after cor- porate taxes), discounted at the unsubsidized market rate (also after-corporate-tax). Thus, if we let $ repre- sent the second term in Equation (7), (4) plus the definition of Gy, from Exhibit 1 can be used to write S as: x ot bem tw(t=T3) STR a eo ‘That is, a firm wishing to issue a rskless claim on itself ‘could issue either risk-free equity atthe rate rg, or risk~ free debt at the tax-subsidized rate ru(I - T,). The net advantage to debt is simply the present value of this ‘opportunity cost saving. ‘Aswhen there are only corporate taxes, there are no adjusted discount rate expressions that will produce ‘the same asset value given by Equation (7) in this case. Conyright © 2001. All Rights Reserved.“ rt Se FINANCIAL MANAGEMENT/AUTUMN 1991, Exhibit 3. Summary of Valuation and Cost of Capital Expressions With Both Corporate and Personal Taxes Panel A. Operating Cash Flow Stream is a Perpetual Annuity; Future Debt Levels Are Known With Certainty ‘Adjusted Present Value v=l+Gp @A1) ‘Weighted Average Cost of Capital ran (5) + ryd(1 — Te) (?) @GA2) Overall and Unlevered Cost of Capital re ( -GL (?)) GA3) Cost of Equity and Unlevered Cost of Capital re=r+ (r—1y(1— Gu) (GAA) Cost of Equity and Beta re = 17 +B (rm — Ne) GAS) Levered and Unlevered Beta Bi=fu (1 +(1-G1) 2) GAS) Panel B: Finite or Perpetual Life; First Debt Tax Shield Panel C: Finite or Perpetual Life; All Debt Tax Shields Certain, Others Uncertain Uncertain ?) 'D' he c+ VitVi von Sites 4 BEL Me oa mG\Y)+ Vist ect) rs (*) +ma(1—Te) (7) (3B2) te () +ma(1— Te) () C2) D (@B3) r= G. (?) Gc) r D _p2 reart fp-m (1 +GL (=) (@B4) rte GCA) re=1¢+Bm—"8) Bs) re= 1+ Bm —"6) @cs) D = D tne (=a. ) B.=Bu (+3) BC.6) Bc=Bu (1 +8) (xa eeod) (86) ‘Thus the APV method is the only one of the three that gives theoretically correct results when the schedule of debt outstanding is known with certainty but the asset’s life is finite. D. Debt Adjusted Once Per Year to a Constant Debt-to-Value Ratio The second approach to obtaining more generally applicable results, as in Miles and Ezzell [18] to as- sume that the firm’s debt ratio is known and that the Conyright © 2001. All Rights Reserved.LLL TAGGART/CONSISTENT VALUATION. actual debt level is adjusted once per year to this target ratio. Extending the Miles-Ezzell analysis to include both corporate and personal taxes thus leads to Equa- tion (3B.1) in Exhibit 3 as the basic valuation relation- ship. Iterating backward from the end of the firm or asset's life, a shown in the Appendix, leads to an ad- justed discount rate expression, (3B.3), which is also consistent with the weighted average cost of capital, (GB2). Expressions (3B.4) and (3B.6) follow in turn from equating (3B.2) with (3B.3). ‘The equations in Panel B of Exhibit 3 are applicable to both finite- and infinite-lived assets using any of the three valuation methods. In fact, they are exact analogues to the Miles-Ezzell equations in Panel B of Exhibit 2 with the same two adjustments that are made in Panel A: T- is réplaced by Gz, and ra is replaced by Ne E, Debt Adjusted Continuously to @ Constant Debt-to-Value Ratio If the firm adjusts its capital structure continuously toa target debt ratio, all future debt tax shields, includ- ing the first year’s, are risky. This implies that the basic valuation relationship is given by Equation (3C.1) in Exhibit 3, which generalizes the Harris-Pringle [14] analysis to include both corporate and personal taxes. Equation (3C.1) can then be used to derive the remain- ing expressions in Panel C of Exhibit 3. These in turn produce identical firm values, for both perpetual and finite-lived assets, regardless of which valuation ‘method is used. ‘A special feature of the continuous-adjustment case is that Equation (2C.6) is identical to Equation (3C.6). ‘That is, the relationship between the levered and un- levered betas is the same, whether or not personal taxes are included in the analysis. As discussed in more detail in Section IV, Myers and Ruback [23] have exploited this fact to show that, under a special assumption about the firm's capital structure, the value of an asset will be the same, regardless of the assumed tax regime. IV. Implementation Issues A. ANumerical Example The use of these equations is illustrated by the ex- ample in Exhibit 4. The first step is to choose the ap- propriate set of valuation and cost of capital expres- sions. Since personal tax rates are present, this calls for the expressions in Exhibit 3, rather than Exhibit 2, The asset has only a 10-period life, so this rules out the per- 16 Exhibit 4. Numerical Example (the equations in Panel B of Exhibit 3 are used to value an asset characterized by the assumed parameter values) A. Assumed Parameter Values 10 periods 100 for all n 028 B. Derived Values 0.2483, from definition in Exhibit 1 0.0615, from Equation (4) 0.1677, from Equation (3B.5) 0.1593, from Equation (38.3) or from (3B.2), if (3B.4) is used to estimate re Ye = 0.2724, from Equation (3B.4) or from (GBS) 484.6, from discounting Cy at r* 2.38, from Equation (3B.6) 2423, from discounting equity cash flows at re ppetuity expressions in Panel A, and if we further sup- pose that the firm adjusts to its target debt ratio once per period rather than continuously, this establishes Panel B as giving the relevant set of expressions. Using the equations in Panel B, we can derive the values shown in the bottom half of Exhibit 4. For example, the adjusted discount rate method calls for using either Equation (4B.2) or (4B.3) to find the over- all cost of capital, r* = 0.1593. Then, discounting the tenyears’ worth of operatingcash flows at this rate gives, V = 484.6. The same value can also be obtained with either ofthe other two valuation methods, but itshould be noted that both are extremely cumbersome to use under the assumed capital structure adjustment seen To implement the flows to equity method, for in- stance, its necessary to know the entire future’ sched- ule of debt service charges. Such a schedule can be Conyright © 2001. All Rights Reserved.FINANCIAL MANAGEMENT/AUTUMN 1991, Exhibit 5. Numerical Example: Period-by-Period Schedule of Value and Debt (based on the assumed parameter ‘values from Exhibit 4, period-by-period firm values are derived by discounting the remaining operating cash flows at the overall cost of capital; the debt ratio is $0% in each period) Period Firm Value Debt ATT.Debt Service Equity Cash Flow Effective Tax Shield ° 4846 2023 S S = 1 4618 2309 ~ 26 740 370 2 4353 2177 239 76.10 353 3 4007 23 254 7459 332 4 3602 1846 za 7293 309 3 3280 1640 21 3s 282 6 2802 1401 315 6853 250 7 2248 1124 Baa 65.85 214 8 1607 803 313 om 1m 9 863 1 409 $942 123 10 S = “asa S491 086 derived by using the ADR method to obtain a period- by-period schedule of asset values, as shown in Exhibi 5, and these can in turn be multiplied by 0.5 to obtain the schedule of outstanding debt, From this, the after- taxdebt service charge (including principal repayment) can be calculated for each period and subtracted from the after-tax operatingcash flow, C, to obtain the equi- ty cash flows shown in Column 5 of Exhibit 5. These cash flows can then be discounted at re = 0.2724 to ob- tain E = 242.3, which is consistent with V = 484.6. ‘To implement the adjusted present value method, the debt schedule in Exhibit 5 can be used to calculate the schedule of effective debt tax shields, rye Gi Dn, as shown in Column 6. However, these must be di counted iteratively, using Equation (3B.1), since only the next period’s cash flow is certain at any given time. Following this procedure, one can duplicate the period- by-period schedule of asset values given in Column 1. Under the assumed capital structure adjustment process, the FTE and APV methods are not only cum- bersome but redundant in this case. To implement either, we effectively need the entire schedule of asset values, but this iswhat we are trying to determine in the first place. Thus, even though all three methods can yield identical results in principle in thiscase, the ADR method is definitely preferred. ‘A second point that emerges from the numerical ex- ample concerns the schedule of debt. Equations such as (3B.2), (3B3), and (3B.) allow one to calculate a current cost of capital that is predicated on an entire schedule of future asset values, as illustrated in Exhibit 5. In fact, however, asset value is random over time, because of the random nature of the expected operating cash flows. As firm value changes over time, the schedule of expected future debt levels needed to main- taina constant debt-to-valuc ratio will also be updated. ‘The example can also give a sense of the magnitude of the errors resulting from inappropriate use of dif- ferent valuation methods. Since the expressions in Panel A of Exhibit 2 are the most familiar from textbooks and the literature, it might be common to use those, even though the asset in question has a finite life and personal taxes are relevant. For the parameter values in Exhibit 4, Equation (2A.5) would giver =0.166 and Equation (2A.3) (the MM cost of capital formula) would give the overall cost of capital as r* = 0.1378, Discounting the ten years’ worth of operating cash flows at r* then gives the asset value as 526.2, an error of 8.6% relative to the true value. This error will increase with asset life, with the dif- ference between G,, and T., and with the difference be- tweenand rg. Forexample, ifwe keep other parameter values the same but move from a 10-year to a per- petual asst life, the estimated asset value is 718.4 using * = 0.1392, an error of 14.4% relative to the correct value of 627.7 that is obtained using r* = 0.1593. ‘Another error to which the analyst might be suscep tible is inappropriate use of the APV method. Suppose the analyst knows the initial debt level is 242.3 but as- sumes this level will remain constant, rather than ‘changing over the asset's life, All other parameter values are as given in Exhibit 4. If the APV method is implemented using Equation (1) inthe text, this results in V = 5132, anerror of 5.9% relative to the true value (of 484.6. Again, this error will increase with asset life, with the difference between Gz and T,, and with the difference between r and re. Conyright © 2001. All Rights Reserved.‘TAGGART/CONSISTENT VALUATION 7 Exhibit 6. Roadmap to Choice of Valuation Method With Corporate and Personal Taxes Panam of Operating Fo Ue eae ‘caren Popul erty nmr Cash ors ‘Assumed eof Faure [DOB Tx Soe Dear Tax Shas ana sie ae Tas ies ‘ett Tax Sos Conan sky Conta Conan ny Constant Dy Y + + Y Faeyr atti ard Parca Faves Bro} Eavaton Fars 5x6] conte Genta reasons | exnbt'3 anon 9 ‘re ead + % £ + Pane’ | UseAny abot pon nv por Other types of errors, however, may be quite negli- gible. Suppose, for instance, that the analyst uses the expressions in Panel C of Exhibit 3, rather than those in Panel B, even though the asset's capital structure is not adjusted continuously. From Equation (3C.3), this results in r* = 0.1591 and V = 485.0, an error of less than 0.1% from the true value. B. The Choice of a Valuation Method Exhibit 6 provides a roadmap that can be used to navigate through the different cost of capital expres- sions and the circumstances under which one of the three valuation methods is preferred to the others. For simplicity, Exhibit 6 is keyed to a tax regime that in- cludes both corporate and personal taxes and thus to the equations in Exhibit 3, but an exactly analogous roadmap could be keyed to Exhibit 2. Given the relevant tax regime, the next question is whether the ‘operating cash flow stream is best viewed asa perpetual annuity or if a finite life and/or uneven cash flows are important characteristics of the asset. Most important, the analyst must decide whether future debt tax shields ‘canbe treated asaknown schedule or whether they vary with future firm values. Ifthe schedule of debt tax shields is known in dollar terms, the APV method is always appropriate, and for finite asset lives it is the only one of the three methods that is even feasible. On the other hand, if debt financ- ing is specified as a fraction of asset value, the ADR method is always appropriate, while the other two methods are cumbersome at best. In the latter case, moreover, the numerical example suggests that it makes little practical difference whether the analyst uses the Miles-Ezzell analogue expressions in Exhibit 3, Panel B or the Harris-Pringle analogue expressions in Exhibit 3, Panel C. This may in turn lead to a preference for Exhibit 3, Panel C, because of the ‘simpler form of the equations. . When Can We Avold the Choice of a Tax Regime? ‘As Hamada and Scholes [13] argue, it may not be obvious which tax regime discussed above is driving asset values. Additionally, if personal taxes are in- cluded, unobservable magnitudes, such as the net tax gain to leverage, Gz, and the risk-free equity rate, rf, ‘ust be estimated to move from one cost of capital ex- pression to another. If the analyst wishes to avoid these problems al- together, there are two special cases in which the choice of the tax regime is irrelevant. The first occurs when all debt tax shields are discounted at r (as in Panel C of Exhibit 2 or 3), and the firm's capital structure is char- acterized by (E/V) = By and (D/V) = (1-By). In that Conyright © 2001. All Rights Reserved.18 ccase, Myers and Ruback [23] have shown that, for both tax regimes, the adjusted discount rate is rd ~BuXt~ T+ Bot o Expression (9) thus provides a useful cost of capital ex- pression when the analyst is uncertain about which tax regime better reflects the true security valuation process. The tradeoff, however, is that the analyst must accept the assumed capital structure. “The second special case occurs when all cash flows are riskless. Ruback [26] has shown under very general conditions that riskless corporate cash flows can be valued by discounting them at the after-corporate-tax riskless interest rate, regardless of the relevant tax regime. This follows by an arbitrage argument from the observation that such a stream can support 100% of its own value in debt financing. The current results are consistent with this analysis, as can be seen from Ex- hibits 2 and 3. When there are only corporate taxes, an all-equity-financed riskless cash flow stream would have an unlevered cost of capital r = rj. If DIV = 1, then, all of the overall cost of capital expressions in Ex- hibit 2 reduce to r* = rq (1 - Te). With corporate and personal taxes, r = rg for a riskless, unlevered stream, and if D/V = 1, the third equation in each panel of Ex- hibit 3 reduces to r* = 7% (1-Gz) . However, from Equation (4) and the definition of Gr, r(1-Gz) = rif] ~ Te). The weighted average cost of capital also reduces tor® = rj(- Te) in this case. V. Summary and Conclusions ‘This paper has analyzed the conditions under which the adjusted present value, adjusted discount rate and flows to equity methodsall lead to identical asset valua~ tions in the presence of corporate and personal taxes. Its principal conclusions are: : Consistent valuation can be achieved if (a) the asset’s operating cash flows and debt service charges, are level perpetuities or (b) the firm maintains a con- stant leverage ratio. Depending on which of these as- sumptions is appropriate, the analyst must use the valuation and cost of capital expressions from only one panel of expressions in Exhibit 3. (i) The expressions in Exhibit 3, which incorporate both corporate and personal taxes, differ from the more familiar expressions in Exhibit 2, which include only corporate taxes, in two ways: T., the corporate tax rate, is replaced by Gz, the net tax advantage to corporate FINANCIAL MANAGEMENT/AUTUMIN 1991 debt, and ry, the risk-free debt rate, is replaced by rey the risk-free equity rate. (iii) Although consistent valuation is possible using ‘any of the three methods when the firm maintains a constant leverage ratio, the adjusted present value and flows to equity methods are cumbersome, and the ad- justed discount rate method is preferred. (iv) When the asset has a finite life but the schedule of outstanding debt is known with certainty, there are no adjusted discount rate expressions for either the overall cost of capital or the cost of equity, so the adjusted present value method must be used in this case, (v) The weighted average cost of capital is robust to changes in both the tax regime and in the perceived risk of interest tax shields. This is because the relationship between the levered cost of equity,re,and the unlevered ccost,r, changes to reflect both tax factors and tax shield risk, leaving the weighted average formula intact. To correctly estimate the weighted average starting from seratch, however, the analyst must use the correct relationship between r and re. A special case of the weighted average cost of capital, proposed by Myers and Ruback [23], does not require specific knowledge of the relationship between r and r,, but does require a specific capital structure assumption. References 1. DJ. Ashton and D.R. Atkins, “Interactions in Corporate ‘Financing and Investment Decisions: A Further Comment,” Joural of Finance (December 1978), pp. 1447-1453. 2. RP. Bey and J.M, Collins, “The Relationship Between Before- and Afler-Tax Yields on Financial Assets,” Financial Review (August 1988), pp. 313-331 3. F Black and MS. Scholes, “The Effects of Dividing Yield and Dividend Policy on Common Stock Prices and Ret ims,” Journal (of Financial Economics (May 1974), pp 1-2 4. RA. Brealey and S.C. Myers, Principle of Corporate Finance, [New York, McGraw Hil 4th edition, 1991, 5. MJ. Brennan, "Taxes, Market Valuation and Corporate Finan- cial Policy," National Tax Joumal (December 1970), pp. 417-427. 6. DR, Chambers, RS. Harris, and JJ. Pringle, “Treatment of Financing Mix in Analyzing Yavestment Opportunities,” Finan- cial Management (Summer 1982), pp. 24-41 7. TE. Conine, J, “Corporate Debt and Corporate Taxes: An Extension,” Journal of Finance (September 1980), pp. 1033- 1037. ER. Ezzell and WA. Kelly, Jr, “An APV Anal ss of Capital Budgeting Under Inflation,” Financial Management (Autumn 1984), pp. 49-54. 9, E. Fama, “Risk-Adjusted Discount Ratesand Capital Budgeting ‘Under Uncertainy,” Joumal of Financial Econcmics (August 1977) pp. 324, Conyright © 2001. All Rights Reserved.‘TAGGART/CONSISTENT VALUATION 10, LR. Frans, E.Broyles. and W-T Carleton Corporate Finance: CConceps and Applications, Boston, Kent Publishing Co 1985. 11, RH. Gordon and 8.G. Malki, "Corporation Finance” in How Taxes Affect Economic Behavior, H., Aaron and J.A. Pechman (eds), Washington, D.C, Brookings Institution, 1981, 12. RS. Hamada, -Porolio Analysis, Market Equilibrium and Cor poration Finance,” Jouma of Finance (March 196), pp. 13-3. 13, RS. Hamada and Myron S. Scholes, “Tates and Corporate inancial Management.” in Recent Advances in Coporae nance, E.l. Altman and M.G. Subrahmanyam (eds. Homewood, I, Richard. levi, 1985. 14, RS. Harris and J Pringle, “Risk-Adjsted Discount Rates — Extension from the Average-Rsk Case,” Jounal of Financial Research (Fall 1985), pp 237-244. 15 LinselbagandH.Ksufol, How to Value Recapitaizatons and Leveraged Buyouts” Coninental Bank Journal of Applied Cor porate Finance Summer 1989), pp. 87-9, 16, W.G. Lenellen and D.R. Emery, “Corporate Debt Management andthe Vale ofthe Fim,"Joumal Financialand Quantiaive ‘Anabss (December 1986), pp 815-825 17, RAW Masuli “The Impact of Capital irutare Change on Firm Some Estimates” Joural of France (March 1983), pp. 107-126. 18, J.Miles and JR Ezzl, “The Weighed Average Cos of Capi tal” Perfect Capital Markets and Project Life: Clarification, Joumal of Financial and Quantitative Anas September 1980), pp. 719-730. 19, Miles and JR. Eze, “Reformulating Tax Shield Valuation: ‘ANote"Joumal of Finance (December 1985), pp. 1485-1492. 20, MAH. Milles, “Debt and Taxes.” Journal of Finance (May 1977), pp.261-276. 21, Fe Mohan’ and MH. Miler, “Corporate Income Tats and the Cost of Capital: A Coretion,” American Economic Review (Bune 1963), pp. 433-43, 22. SC. Myers, “Interactions of Corporate Financing and Invest- ment Decisions —Implcation fo Capital Budgeting" Journal of France (March 197), pp. 28.8C. Mrs and RS. Ruback, “Discounting Rules for Risky ‘Auscts" Harvard Business School Working Paper, November 198. 24. SC. Myersand SM. Tumbul “Ceptal Budgeting and he Capi. tal Asset Pricing Model Good News and Bad News," Joumal of Finance (May 1977) pp. 321-332 28. GE Pinches and LW. Courtney, Lows 1-23 for Financial “Management New York, Harper and Row, 1989. 26, RS. Ruback, “Calculating the Market Value of Risk-Free Cash Flows” Jounal of Financial Economics (March 1986) p.323- 338 27. ME. Rubinscin, “A Mean-Variance Synthesis of Corporate Joumal of Finance (arch 1973), pp 167- 28, G.A Sick," Tax-Adjusted Discount Rates,” Management Science (December 1990), pp. 1432-1450. 20.G.A. Sick, “A Certainty-Equivalent Approach to Capital Budgeting.” Financial Management (Winter 1986), pp. 23-32. 30, R.A. Taggart, Jr, “Capital Budgeting and the Financing Decision: An Exposition,” Financia! Management (Summer 1977), pp. 59-66 31. J. Yagil, “On Valuation, Beta and the Cost of Equity Capital,” Journal of Financial and Quanthatve Anabsis (September 1982), pp. 441-448, 1” Appendix |. Derivation of Equation (7) Starting at the end of the valuation horizon, suppose the firm will pay a liquidating dividend to its shareholders at time N, consisting of the, after-tax ‘operating cash flow, Cy, minus the after-tax interest and principal on its beginning-of-period debt, Dy.1. Personal taxes on equity income are levied against dividends plus capital gains, o beginning equity value, En-t, Serves as a personal tax shield. Letting CEQy denote the pre-personal-tax certain- ty-equivalent of Ciy, the value of the firm’s equity and debt at N - 1 can be expressed as: Eyre I=Tpyl (CHOW ~ dl = TPH—1-Py—t) (1= Ty) + Tye Ev—tl- (al) 1 Dy-a= 4d ~ T,)Dy-1+ Dy). (42 WA TE GAT= To A TpDw—a# Dead (42) Since these two discount rates must be the same in equilibrium, we can express beginning-of-period firm value, Vy. = Ey. + Dw-t, 98 Vu= l(t ~ Tye) + re ~ Tpe)] = CEQn—1(1 = Tye) +d T) [SSE ove. (43) ‘Then using the definition of Gz, text Equation (4), and solving for Vy. CEQN Vat 1eG,Dn- NATE ig ee. (as) Iterating backward in similar fashion, the value of the firm at any time ¢is given by N CEQ» 4G Danr WBC ti nan Urq When risk-adjusted discount rates are appropriate (see [9], [24], [28)), (AS) can alsobe written in the more familiar form of Equation (7) in the text. Il. Derivation of Equation (38.3) from Exhibit 3 First, write (A4) in its risk-adjusted form as, Conyright © 2001. All Rights Reserved.FINANCIAL MANAGEMENT/AUTUMIN 1991 terest paid at time N- 1, and Vy.1. Discounting Vv. i the ratio of debt to firm value is a constant, we can W express (A6) as ued & oh 1 Mild +H GLDV OF HP at the unlevered cost of capital, r, backward (A7) yields, for any time t: oy G+y ‘Setting the term in square brackets equal to (1 + r*) 7 (47) andsolvingforr* then gives Equation (38:3) in Exhibit 3. Vy. is in turn equal to the sum of the values as of time N-2 of three terms: Cy.1, the net tax advantage of in- eration of TEXAS A&M UNIVERSITY i COLLEGE OF BUSINESS ADMINISTRATION Invites applications for the position of Head, Department of Finance. This position offers the pppor- tunity to demonstrate academic and administrative leadership in a dynamic university environment. ‘The Finance Department is one of five academic departments in the College of Business Administration and Graduate College of Business and has a well-established reputation for excellence in research and teaching, ‘Candidates should have an earned doctorate in finance or closely related field, and possess a/strong record of scholarly achievement. They should have administrative skill and the ability to interact with business, ‘executives. Salary is competitive. The target appointment date is Summer 1992. | Interested persons are encouraged to contact Gary Trennepohl, Associate Dean, College of Business Administration, Texas A&M University, College Station, Texas 77843-4113, telephone (409) sis-a7it ‘Texas A&M University is an Equal Opportunity Employer. Conyright © 2001. All Rights Reserved.