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Manfred Frühwirth/Markus Schwaiger *

* Dr. Manfred Frühwirth is associate professor at the Department of Corporate Finance, Vienna University of Economics and Business Administration, Dr. Markus Schwaiger is assistant professor at the same department. Corresponding author: Manfred Frühwirth, Nordbergstraße 15, A-1090 Vienna, Austria, Phone: +43/1/31336/4252, Fax: +43/1/31336/736, Manfred.Fruehwirth@wu-wien.ac.at

DCF Business Valuation with Imputed Interest on the Stock of Equity

Abstract

In the last two decades several European countries implemented tax systems allowing for the deduction of imputed equity interest from a company’s tax base. This paper integrates the tax benefits resulting from imputed interest on the stock of equity into business valuation. Three discounted cash flow valuation methods are used to this end: the equity method, the APV method and the entity method. Intertemporal differences in risk require the use of various risk-adjusted term structures of interest rates in the equity method as well as the APV method. Using the equity method we show that the well-known market-to-book ratio of the constant growth dividend discount model holds in a risk-adjusted form. When applying the APV method with imputed equity interest an adjustment is necessary for each business, also for an unlevered company, to account for the tax shield resulting from equity financing. A closed-form solution is presented for the value of this tax benefit. We furthermore derive the WACC under imputed interest on the stock of equity and the adjustment of the cost of equity which is necessary to derive the WACC as a weighted average of cost of equity and debt.

EFM classification: 210, 330, 710 JEL classification: G24, H25, K34, M40 Keywords: Business Valuation, DCF Methods, Imputed Interest on the Stock of Equity, Dual Income Tax System

1

Introduction

The relative advantage of debt finance over equity finance taking into account the tax consequences of either is common knowledge in finance theory and stems from the deductibility of debt interest payments from the tax base of companies. From a capital structure perspective, this makes debt finance more attractive than equity finance, therefore distorting financing decisions of corporations. Attempting to reduce the distorting effect of taxes on the capital structure choice of companies, the idea of deducting (fictitious) interest on a company's equity in the same way as debt interest has been born in the 1980s. Since then legislators and scientists in several countries have taken up this idea and created tax regimes in which the deductibility of imputed equity interest compensates (at least in part) for the preferential tax treatment of debt. In light of the potential consequences of the implementation of the new Basel accord on capital adequacy (commonly referred to as "Basel II") the perception of the need for equity finance has even increased. In most tax regimes, where deductions for imputed equity interest are considered, equity interest is computed from the stock of equity. Generically, these tax regimes work as follows: In addition to interest on debt, imputed interest expenses on equity are deductible from a company’s tax base. To this end, an equity interest rate is fixed for tax purposes by government bodies, which comprises a risk premium on the interest rate of government bonds. The equity interest rate is then applied to a company’s book equity holdings, the resulting amount being deducted from a company’s tax base in the same way as other expenses. The remainder is then taxed at the applicable tax rate. In general, however, equity interest does not remain untaxed but is taxed at a lower rate compared to ordinary income.1 Such tax regimes are usually referred to as "Dual Income Tax Regime" in which part of the business's earnings (i.e., the imputed equity interest) are taxed at a reduced rate. Examples of such tax regimes are the tax systems in several Nordic countries. Norway has introduced the deductibility of imputed equity interest in the 1990s and has been followed suit by Finland. Similar, however more complex, systems

1

A zero tax rate for equity interest can be seen as a special case.

1

This paper provides a framework for the valuation of businesses when the tax regime allows for imputed interest on the stock of equity to be considered. The prime reasoning for the existence of imputed equity interest has been its potential influence on the capital structure choice of companies. Similar proposals have also been put forward for changes in the German and Swiss legislation (see Neue Züricher Zeitung from November 2. we derive the weighted average cost of capital (WACC) to be used under the entity method including the appropriate adjustment to the cost of equity reflecting the value of equity tax shields. The structure of the paper is as follows: Chapter 2 presents the model. In a multi-period value-driver model under risk we extend common discounted cash flow (DCF) techniques. We show that the risk-adjusted discount rates for the tax shields from imputed equity interest are equivalent to those for debt tax shields. namely the equity method. Finally. the adjusted present value (APV) method and the entity method to include the deductibility of imputed interest on the stock of equity. Several studies deal with this issue for the respective tax systems (see e. The existence of such legislation together with the actual level of equity financing undertaken by companies makes it necessary to integrate the preferential treatment of equity into existing business valuation models. as described in Rose/Wiswesser (1998). 2000 and Rose (2002)). For the United Kingdom a corresponding "Allowance for Corporate Equity" has been proposed (see IFS (1991)). As a variant. Chapter 4 deals with the 2 . as described by Bordignon/Giannini/Panteghini (2000) or Arachi/Alworth (2001). Devereux/Freeman (1991). Chapter 3 covers the growth in expected equity in our model.are in place in Denmark and Sweden (see Soerensen (1998)). and Italy. This is especially relevant for businesses with a large equity ratios.g. as well. As for the APV method a closed-form solution is presented for the value of the tax benefit arising from equity financing. Arachi/Alworth (2001) and Bogner/Frühwirth/Höger (2002)). Other examples of tax regimes with interest on the stock of equity are the former tax systems in Croatia. We thereby derive a market-to-book ratio endogenous to our model. Boadway/Bruce (1984). the Austrian tax regime allows for (fictitious) equity interest on equity increase to be deducted.

3 This assumption enables us to get closed-form solutions in the following sections. Chapter 6 integrates imputed interest on the stock of equity into the APV method. The model presented in this paper would correspond to the final stage of such a multi-stage model and is thus a prerequisite for the implementation of a multi-stage model. described in the sequel. Chapter 5 uses the equity method to calculate the business value in consideration of imputed interest on the stock of equity.g.or multi-stage model would be possible.3 In the model uncertainty arises from the stochastic development of the book return on investment before interest and taxes in each year t (symbolized by ROIt). 4 3 . The methodology to be applied to the valuation of payments in the previous stages is identical to that in the final stage. As imputed equity interest is calculated on the basis of book equity. the assumption of a 2. a constant capital structure at book values is assumed. 2 Model The object of our study is the following business: The company has an infinite life span2 and riskless debt outstanding in the form of perpetual bonds with a par value of Dt at any time t.valuation methodology used. distribution of earnings and capital increase for the year t-1). This model is based on the book return on investment because the imputed interest on equity is based on book equity. to the total book capital at the beginning of the year t after the distribution of earnings from the year t-1. the expected development of the return on investment would have to be predicted for each stage. Under a constant book-to-market ratio. Papers in the line of Schwartz/Aronson (1967) find empirical evidence that firms exhibit a tendency to maintain a constant capital structure over time. Finally. The capital structure at book values. In order to implement this generalization.. It is assumed that in any 2 As a generalization of this model. EBITt. see Ross/Westerfield/Jaffee (1999) or Miles/Ezzell (1980)). TCt-1 (= total capital at the end of year t-1. denoted by ν = Dt/EQt. this assumption is identical to the frequent assumption of a constant capital structure at market values (e.4 The return on investment in year t expected on the basis of the information available at t-1 is constant over time and described by the parameter ROI . The book returns on investment in different years are assumed to be uncorrelated. Book equity at time t is symbolized by EQt. specifically: after payment of business taxes. which is calculated as the ratio of the earnings before interest and taxes in year t. Chapter 8 concludes.however at the expense of analytical tractability. using the same methodology . Chapter 7 deals with the entity method under imputed interest on the stock of equity. is assumed to be constant over time. Serial correlation could easily be incorporated into the model.

5 4 . the relative capital increase must be the same for equity and debt. The increase of total capital by means of equity or debt is performed with due attention to the constant capital structure. EBITt. the total capital is increased by the product of EBIT in year t. The parameter q is a consequence of the investment program and of the business's resulting financing needs. Therefore. Debt interest and imputed interest on equity can be deducted from earnings for tax purposes. Deductions for imputed interest on equity are subject to preferential tax treatment at the rate τS <τK. At the end of year t. Personal taxes are disregarded in this paper (e.g. and the constant factor q. The debt increase is implemented by issuing new perpetual bonds. let us focus on the growth of expected equity over time within our model: Because the increase in the total book capital is qEBITt = qTCt-1ROIt and the book capital structure remains constant. ν = Dt/EQt. The equity increase is performed either by means of plow-back or the issuance of new equity. EQt-1. It can be interpreted intuitively as the (net) plowback ratio. in states of higher earnings. see Ross/Westerfield/Jaffee (2001)).. An alternative assumption would involve loss compensation. by the equity interest rate re. Concerning the tax regime. Taxes for the year t are to be paid at the end of the year t.5 The covariance (on the basis of the information available as of t-1) between the return on investment over year t and the return of the market portfolio over year t is constant over time and symbolized by ρ.case the return on investment is sufficiently high to allow the use of all tax shields. earnings are subject to a constant tax at the rate τK. which is assumed to be constant over time. 3 Evolution of the stock of equity over time To begin with. EQt = EQt −1 + qEQt −1 ROI t = EQt −1 (1 + qROI t ) . This manner of modelling is common in the valuation of (debt) tax shields. The imputed interest on equity for year t is calculated by multiplying the book equity at the beginning of year t. Thus. more capital is injected into the business than in states with lower earnings.

by the question whether they are deterministic or stochastic. 4 The Valuation Methodology of Fama (1977) For the valuation of the cash flows from the firm a valuation model is required. in addition to the assumptions of Fama (1977). 6 5 . Stapleton (1971). In the sequel we will use the model of Fama (1977). Myers/Turnbull (1977)).models with stationary parameters (e. stochastic parameters (e. Fama. conditional on the information available as of time t-1. An example are models in the line of the consumption-oriented CAPM (e. Several models assume that the single-period Sharpe/Lintner/Mossin-CAPM holds in each period . by continuous/discrete time models. by the (non-)stationarity of the CAPM parameters and in case of non-stationary parameters. Alternative models can be grouped by the number of cash flows observed. the expected equity in our model grows at an annual rate of q ROI . Mossin (1966)) (frequently used in industry) and its easy implementation facilitating the tractability of valuation formulae. is: E[EQt ] = EQ0 1 + q ROI ( ) t Thus. using the law of iterated expectations. models with non-stationary. Stevens (1974)). In addition. deterministic parameters (e. The unconditional expected value of equity. The model is based on the assumptions of the one-period CAPM. Lintner (1965). by their (in-) consistency with the single-period Sharpe/Lintner/Mossin CAPM. Let the risk-free interest rate be denoted by rf.g. deterministic risk-free interest rate and market price of risk. Bogue/Roll (1974). In our model we assume.g. Breeden (1979)). Bierman/Hass (1973). we opted for the Fama (1977) model. Breeden/Litzenberger (1978). where E[∏] stands for the expectation operator and Et[∏] denotes the expected value conditional on the information available at t. because of its compatibility with the single-period CAPM (see Sharpe (1964). and the market price of risk by λ.g. assumes non-stationary. Other researchers methodologically deviate from a simple extension of the single-period CAPM. in general. Rubinstein (1976). that the risk-free interest rate as well as the market price of risk are constant over time.The expected value of EQt.g. Although several alternative models have been put forward6. is E t −1 [EQt ] = E t −1 [EQt −1 (1 + qROI t )] = EQt −1 1 + q ROI ( ) . Bierman/Smidt (1975)) and models with non-stationary.

the following discount rates obtain for the above cash flow structure (see Appendix 1): k (s.e.e.Fama uses the following equation for the value of a cash flow stream Z1.t) is the discount rate for the cash flow occurring at time t. As will be shown later in the paper. for the period from s-1 to s (i. p. the (unconditional) expected cash flow can be derived using the fact that the returns on investment in different years are uncorrelated and applying the expected growth rate as derived in Chapter 3: E [Z t ] = E [EQt −1 ](aE [ROI t ] + b ) = EQ0 1 + q ROI ( ) (a ROI + b) t −1 Within the Fama (1977) framework. t ) = (1 + r f ) a ROI + b − 1 a ROI + b for s = t Equation 2 with ROI = ROI − λρ . all cash flows in our model can be represented in this way. t ) = (1 + r f )1 + q ROI − 1 1 + q ROI for s < t k (s. … ZT (see Fama (1977). the risk-adjusted expected return on investment. 19): PV = ∑ t =1 T E [Z t ] ∏1 + k (s. let us assume the following cash flow structure: Zt= EQt-1(aROIt+b) Equation 1 where a and b are deterministic parameters. Zt. discounting from time s to time s-1). For the time being. ROI can be interpreted as the certainty equivalent of the return on investment. Z2. i. For this cash flow structure. t ) s =1 t where k(s. q ROI 6 .

t ) s =1 t = ( t −1 ) (a ROI + b) t −1 a ROI + b (1 + r f ) a ROI + b = EQ0 1 + q ROI ( (1 + r ) f ) (a ROI + b) t −1 t The numerator in the right-hand term is the certainty equivalent of the cash flow in year t. we will deal with a growing perpetuity consisting of payments of this structure. Thus. The risk-adjusted discount rate for s = t is calculated using the risk-free interest rate and the ratio of the actually expected cash flow to the risk-adjusted expected cash flow. In the sequel. Plugging the values 7 . This representation will give the corresponding values for a and b. ROIt affects Zt directly. the riskadjusted expected growth rate.therefore is the certainty equivalent of the company growth rate. The reasoning for the difference in kE(s. Applying the discount rates to the unconditional expectation of the cash flow gives the present value of cash flow Zt: E [Z t ] EQ0 1 + q ROI 1 + q ROI (1 + r f ) 1 + q ROI PV (Z t ) = ∏ 1 + k (s . We therefore transform the present value representation using riskadjusted discount rates on the left-hand side into a certainty equivalent representation on the right-hand side. Z t = EQt −1 (aROI t + b ) . however. of EQ0 a ROI + b r f − q ROI ( ) PV = ( ) Equation 3 In the sequel. the risk-adjusted discount rate for s < t is obtained using the risk-free interest rate and the ratio of the actually expected growth factor to the risk-adjusted expected growth factor. In the final year s = t.t) between the cases s = t and s < t lies in the cash flow structure of our model. where risk is resolved differently in the years s < t and s = t. PV. Whenever s < t the returns on investment enter into cash flow indirectly through its impact on EQt-1. this gives a present value of the growing perpetuity. i. we will show that both for the equity method and for the APV method the respective cash flows are of the structure given in Equation 1. With the growth rate of the perpetuity being q ROI and the first cash flow EQ0 a ROI + b .e.

the increase in equity.EIt Therefore. 5 Equity Method The equity method will be the first of the three DCF methods covered in this paper. The free cash flow to equity holders. computing the free cash flow to equity holders requires the computation of earnings after taxes and equity increase. is derived from EBIT by deducting debt interest. EBITt equals TC t −1 ROI t . is derived. denoted as EAT. Damodaran (1992)). Thus. the free cash flow to equity holders is simply earnings after taxes minus increase in equity. which is necessary for valuation. free cash flows to equity holders are discounted with a rate adjusted to account for financial and business risk as well as imputed interest on equity. capital expenditure less depreciation (together: net investments) plus increase in working capital must equal the increase in total capital (due to the balance sheet equation). 7 8 . taxes.7 EBIT minus debt interest and taxes corresponds to earnings after taxes. For year t this gives: FCFt = EATt .g.for a and b into Equation 2 and Equation 3 will then give the appropriate discount rates and the present value of the respective cash flow streams. denoted as FCFE. Damodaran (1992)) we assume that there are no changes in accounting provisions in any year. Because debt is In analogy to existing literature (e. Furthermore. the free cash flow to equity holders. 5.1 Free Cash Flow to Equity In a first step. capital expenditure and any increase in working capital (>0 or <0) and adding depreciation and debt increase (see e. the free cash flow is earnings after taxes less increase in total capital plus debt increase. We begin with earnings after taxes: From the definition of ROIt.g. As the increase in total capital minus debt increase is. symbolized by EI. of course. Under the equity method.

earnings before taxes. To compute the tax burden. EBT. debt interest amounts to Dt-1rf.τS) represents the differential between the reduced tax rate and the ordinary tax rate in the dual income tax system. Earnings after taxes in year t. TAXt: EATt = EQt −1 ROI t (1 + ν ) − νr f . is the difference between EBTt and IIEt: TBt = EQt −1 ROI t (1 + v ) − vr f − EQt −1 re = EQt −1 ROI t (1 + v ) − vr f − re [ ] [ ] The tax liability (including reduced tax on the equity interest) in year t. is thus: EBTt = TC t −1 ROI t − Dt −1 r f = EQt −1 ROI t (1 + ν ) − νr f [ ] as Dt=nEQt. to which τK is applied. EATt.risk-free. The free cash flow to equity holders is thus: FCFt E = EATt − EI t = = EQt −1 ROI t [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) [ ] Equation 4 9 . is thus: TAX t = EQt −1 ROI t (1 + v ) − vr f − re τ K + EQt −1 reτ S = = EQt −1 t K [ [ROI (1 + ν )τ ] − νr f τ K − re (τ K − τ S ) ] The expression (τK . It amounts to: IIEt = EQt −1 re The tax base in year t. are the difference between earnings before taxes. and the tax liability in year t. In year t. TAXt. EBTt. the imputed interest on equity in year t has to be calculated.EQt −1 ROI t (1 + ν )τ K − νr f τ K − re (τ K − τ S ) = = EQt −1 t K e K [ ] [ [ROI (1 + ν )(1 − τ ) + r (τ ] − τ S ) − νr f (1 − τ K ) ] As described in Chapter 3 the increase in equity is EI t = EQt −1 qROI t . TBt.

EQt −1νr f (1 − τ K ) . t ) = (1 + r f )1 + q ROI − 1 1 + q ROI for s < t The reasoning for the difference in kE(s.t) between the cases s = t and s < t lies in the fact.t) is therefore: k E (s. the systematic risk of the ratio between two conditional E expected values of FCFt (conditional on the information available at different points in time) is relevant. 10 . Substituting for a and b in Equation 3 the value of equity at an arbitrary time t is: 8 Technically. t ) = (1 + r f a = (1 + ν )(1 − τ K ) − q ) ROI [(1 + ν )(1 − τ ) − q] + r (τ K e K − τ S ) − νr f (1 − τ K ) ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) −1 for s = t k E (s. which leads to a corresponding increase in complexity in the discount rate when s = t. that as explained in Chapter 4. 5. EQt −1 ROI t (1 + ν )(1 − τ K ) .t) is smaller in the years s < t than for s = t. Thus.8 It can be shown that – given ρ > 0 . in cases where s < t.kE(s. a reduction for the increase in equity EQt −1 qROI t .2 Valuation using the Equity Method The structure of the free cash flow in Equation 4 shows that one can use Equation 1 to Equation 3 substituting for a and b as follows: b = re (τ K − τ S ) − νr f (1 − τ K ) The discount rate kE(s.Thus the free cash flow of year t is composed of the after tax earnings of an equivalent unlevered company which does not use equity tax shields. which could of course also be negative. while in the case where s = t the systematic risk of the ratio of the actual payment FCFt E to the expected value (conditional on the information available as of t-1) of FCFt E is relevant. risk is resolved differently: For all years s < t the return on investment enters into the free cash flow indirectly via EQt-1 whereas for the last year s = t ROIt affects the cash flow directly. the equity tax shields EQt −1 re (τ K − τ S ) and the debt interest charge reduced by the resulting debt tax shields. less risk is resolved in each year s < t than in the final year s = t.

the higher the value of equity.V EQ . which is denoted by Vt. This market-tobook ratio can be contrasted with the well-known market-to-book ratio from the Gordon constant growth dividend discount model (which is also independent of time and state): MBRt = = 11 . the growth rate is q ROI and the discount rate is rf. Vt = V EQ . The total value of the business. is then calculated by adding the values of equity and debt. the lower the systematic risk in the return on investment. the market price of risk and the covariance are only contained in ROI = ROI − λρ .t = EQt ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) r f − q ROI [ ] Equation 5 VEQ.3 Market-To-Book Ratio [ ] From Equation 5 an endogenous market-to-book ratio MBRt arises: V EQ . each at time t.t (with the exception of EQt). In Equation 5 it becomes clear that the expected return on investment.t EQt ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) r f − q ROI Equation 6 The determinants correspond to those of VEQ.t is easily derived by applying the present value factor of a constantly growing perpetuity to the certainty equivalents as from time t: The (certainty equivalent of the) first cash flow is EQt ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) . The expected return on investment is thus only accounted for in its risk-adjusted form. The value of equity naturally increases along with the risk-adjusted expected return on investment.t + Dt 5. Therefore. As can be seen the market-to-book ratio is independent of time and state.

MBR = ROE − g kE − g where ROE is the expected return on book equity. 12 . g is the expected growth rate and kE is the cost of equity capital. However. Monkhouse (1997) also uses the APV approach for business valuation within the Australian tax system.9 Any comparison of the market-to-book ratio from the constant growth dividend discount model with the one in our model requires the specification of the expected return on equity. The risk-adjusted representation requires the use of a risk-adjusted expected return on equity instead of ROE as well as discounting with the riskfree rate instead of kE. 6 APV Method In its basic form. the APV method is based on Myers (1974). For a formal definition and computation of kE see Chapter 7. For example.t) derived above. For a detailed derivation see Appendix 2. the expected growth rate (in our representation the risk-adjusted expected growth rate as derived above) has to be subtracted in both numerator and denominator. however based on a risk-adjusted representation: ROE − g rf − g MBR = where ROE represents the risk-adjusted expected return on equity and g = q ROI stands for the risk-adjusted expected growth rate. The source of this approach lies in a model world with only one business tax with deductible debt interest. the expected growth rate and the discount rate. that the market-to-book-ratio of Equation 6 is consistent with the market-to-book ratio from the dividend discount model. Drukarczyk/Richter (1995) and Hachmeister (1999) use the APV approach for the valuation of financing effects in the German tax system. 9 Note that the cost of capital kE implicitly includes the forward rates kE(s. It can be shown. the APV approach has been applied also to real-world and far more complex tax systems. As in the dividend discount model.

it is necessary to examine the free cash flow of the unlevered company for any year t.this group includes businesses with different equity levels and thus different equity tax shields. a fictitious unlevered company which does not claim equity tax shields has to be selected as the point of departure. if the APV approach is applied to a tax regime with imputed interest on equity. 6. Due to the regulations governing imputed interest on equity. For the same reasons as in Chapter 5.The objective of this chapter is to extend the APV approach to a tax regime with imputed interest on the stock of equity. the unlevered (but otherwise equivalent) U which is equal to the total capital of the company at time 0 has equity EQ0 levered business: U EQ0 = TC0 = EQ0(1+ν) For the purpose of valuation. Owing to the fact that even businesses financed solely by equity are not homogenous . the following equation must be used: V0 = V U + PV (TSD ) + PV (TSE ) where VU = Market value (at time 0) of a company which is unlevered but otherwise equivalent and does not claim the tax benefit from imputed interest on equity PV(TSD) = Present value of the tax shield arising from debt financing PV(TSE) = Present value of the tax shield arising from imputed interest on equity The goal of this section is the valuation of the individual components.1 Valuation of the Unlevered Company that does not Claim Equity Tax Shields In contrast to the levered company. the free cash flow is the difference between earnings after taxes and 13 . The tax benefit arising from equity financing has to be added to the existing tax benefit arising from debt financing. an adjustment to account for this imputed interest is necessary in the case of unlevered companies too. denoted by FCFtU. Therefore.

has to be subtracted: U FCFtU = EQtU 1 − τ K ) − qEQtU 1 − τ K − q) −1 ROI t ( −1 ROI t = EQt −1 ROI t ( Equation 7 Recurring to Equation 1 to Equation 3 yields10 a = 1−τ K − q b=0 By substituting for a and b in Equation 2 we get kU (s. the earnings after taxes of this unlevered company are EATtU = EQtU 1 − τ K ) . 10 As EQ tU =EQt(1+n). the growth rate of EQ tU equals that of EQt. that risk is resolved differently.t) is the risk-adjusted discount rate (for the period from s-1 to s) for valuating the free cash flow of the unlevered company in year t. t ) = (1 + r f ) (1 − τ (1 − τ K − q )ROI K − q )ROI − 1 = (1 + r f ) ROI − 1 ROI for s = t 1 + q ROI kU (s. The EBIT of the unlevered company in year t. Once corporate tax is subtracted. less risk is resolved in each year s < t than in the final year s = t. The reason for the difference in kU(s.equity increase. Thus.t) between the cases s = t and s < t again lies in the fact. is EBITtU = EQtU −1 ROI t . In order to receive the free cash flow. t ) = (1 + rf ) −1 1 + q ROI for s < t where kU(s. qEBITtU = qEQtU −1 ROI t . As under the equity method – given ρ > 0 – kU(s. 14 . which is by definition equal to EBT in the same year. −1 ROI t ( the equity increase.t) is smaller in the years s < t than for s = t.

. For s = t kU(s.t) is identical to the one under the equity method. kE(s. the systematic risk in the free cash flow of the unlevered company is identical to the systematic risk in the return on investment. this is no longer the case for the ratio of the actual payment FCFtU to the expected value conditional on the information available at t-1 (s = t).t). The connection between the discount rates kU(s.t) with the ratio ROI / ROI reflecting the difference between the actual expected return on investment and the risk-adjusted expected return on investment.11 The difference in tax treatment (elimination of tax shields for the unlevered company) only comes into play in the final year (s = t).e. Substituting for a and b in Equation 3. however. is the fact that the (risk-adjusted) expected growth rates are equal for both companies.t) and kE(s. 12 15 .t) for s < t and s = t can be explained by the following observation: The difference between the levered and the unlevered company consists on the one hand in the amount of U = EQ0(1+ν)]. The difference in equity levels is irrelevant because it has no influence on how much systematic risk is resolved in the individual years (the equity level drops in the derivation of the discount rate). while on the other hand the unlevered company is equity [i.When s < t.12 In summary.t) is different from kE(s. This arises from the lack of debt tax shields as well as our definition of the unlevered company under the APV method (equity tax shields are not claimed). Technically. the systematic risk in the free cash flow of the unlevered company is identical to that in the free cash flow of the levered business (under the equity method) when s < t (as for both companies the returns on investment enter into the free cash flow indirectly via the level of equity). the value of the unlevered company is: U EQ0 ROI (1 − τ K − q ) VU = r f − q ROI = EQ0 (1 + ν )ROI (1 − τ K − q ) r f − q ROI 11 What is important. this is due to the fact that whereas the corresponding differences in the ratio between two conditional expected values (s < t) cancel out. For s = t. the discount rate kU(s. EQ0 subject to different tax treatment.

Using the discount rate for the levered company is (for s < t) identical to using the discount rate for the unlevered company. Harris/Pringle (1985). q ROI is the risk-adjusted expected growth rate. Substituting in Equation 2 yields kTSD (s. Thus.t) is the risk-adjusted discount rate (for the period from s-1 to s) for valuating the debt tax shields in year t. kE(s. and rf results from the use of the certainty equivalents. t ) = (1 + rf ) 1 + q ROI for s < t where kTSD(s. debt interest 16 . In the case where s = t the discount rate is the risk-free interest rate rf. 6. Owing to the constant capital structure.The economic interpretation corresponds to its counterpart under the equity method. The numerator contains the certainty equivalent of the first free cash flow. Ruback (1995) and Richter (2002).2 Valuation of Debt Tax Shields The debt tax shields in year t are TSDt = Dt-1rfτK = EQt-1νrfτK so that we can use Equation 1 to Equation 3 with a = 0 and b = νr f τ K . for s < t the discount rate kTSD(s. Therefore. this result is consistent with the results of Miles/Ezzell (1980). For s = t.t) is identical to its counterpart under the equity method. Economically speaking. but the stock of debt outstanding and therefore the resulting tax benefit from debt is not (because due to the assumption of a constant capital structure the volume of debt fluctuates with the volume of equity capital). for s < t debt is (default) risk-free. debt interest at the end of year t is the product of debt at the beginning of year t and the riskless rate.t). t ) = (1 + rf ) νrf τ K − 1 = rf νrf τ K for s = t 1 + q ROI −1 kTSD (s. As debt is furthermore default risk-free. the systematic risk of debt tax shields is equivalent to that of equity under the equity method.

Due to the assumption of a constant capital structure. Modigliani/Miller (1963)). Finally. 6. In the final year t the systematic risk in debt tax shields is thus 0. thus making the tax shields certain in the first year. A risk-adjustment is not necessary for these tax shields because according to our model (see Chapter 2) these can be used in any case and EQ0 is known at time 0.and hence also the tax benefits from debt interest is predictable for one year.g. the tax shields in the ensuing years are subject to the same risk as equity is (with a one year time lag). Again substituting for a and b in Equation 3 yields the value of all debt tax shields: PV (TSD ) = EQ0νr f τ K r f − q ROI The numerator contains the debt tax shields for the first year. the net tax benefit in year t is: TSE t = EQt −1 re (τ K − τ S ) Thus. For this reason. The imputed interest on the stock of equity in year t has been derived in Chapter 5: IIEt = EQt −1 re If all tax effects (including the reduced tax on the imputed interest on the stock of equity) are taken into account.3 Valuation of Equity Tax Shields The valuation of the equity tax shields is performed with the same methodology. we can use Equation 1 to Equation 3 with a=0 17 . it is easy to see that for q = 0 which implies constant debt PV(TSD) equals D0τK corresponding to the standard case dealt with in literature (see e. the growth rate to be used is once again the risk-adjusted growth rate q ROI .

Equity tax shields grow at the risk-adjusted expected growth rate q ROI in the ensuing years. as is the case for the free cash flow under the equity method.t) is the equivalence of systematic risk of equity tax shields and debt tax shields.4 APV Method .t). The reason for the equality of kTSE(s.Summary Summing up.t).g. s = t). is: kTSE(s. in both cases the stock of equity/debt are already known. the value of the equity tax shields is PV (TSE ) = EQ0 re (τ K − τ S ) r f -q ROI . The numerator contains the equity tax shields from the first year. the discount rate for equity tax shields. 6. Furthermore. In the last period s = t e. By plugging in a and b into Equation 3. for s < t kTSE(s.t) and kTSD(s. leaving no more uncertainty to be resolved in our model. namely the evolution of the stochastic return on investment of the business under consideration.t) = rf for s = t k TSE (s.b = re (τ K − τ S ) Therefore. t ) = (1 + r f )1 + q ROI − 1 1 + q ROI for s < t Therefore the discount rates for equity and debt tax shields are the same for all years (s < t.t) equals its counterpart under the equity method. A constant capital structure at book values exposes equity and debt tax shields to the same source of variation. kTSE(s.. As for the debt tax shields in the first year. again. no risk adjustment is necessary because the equity interest in the first year is computed from the equity stock at time 0. the value of the business using the APV method is the total value of the unlevered business which does not claim equity tax shields and the value of debt and equity tax shields: 18 . kE(s. The derivation is based on a constantly growing perpetuity.

we follow the common methodology of deducing the weighted average cost of capital (see e. the entity method. i. V EQ .t + Dt ) ] −1 The right-hand term corresponds to the required rate of return at time t of a levered company deducting imputed interest on equity: The numerator corresponds to the expected cash flow to equity and debt holders at time t+1 and the denominator stands for the value of the company at time t. Miles/Ezzell (1980). wt. Using for VEQ.t = EQt MBR and Dt = EQtν . 7 Entity Method As for the third DCF method.g.0 + D0. debt and equity tax shields) are exclusively included in the discount rate. the objective of this chapter is to determine the weighted average cost of capital (WACC) in consideration of imputed interest on the stock of equity.t + Dt) as EQt (MBR + ν ) .e.V0 = V U + PV (TSD ) + PV (TSE ) Proposition 1: The value of the business under the APV method equals the value of the business under the equity method. We can express the market value of the business (VEQ. The proof of Proposition 1 can be found in Appendix 3. In order to determine the WACC. wt. gives the weighted average cost of capital for a company with infinite life.t and Dt the values derived in the previous chapters. Furthermore. This implies that all effects induced by financing decisions (i. E FCFtU with the WACC corresponds to V0 = VEQ. as expected return for equity and debt holders over the period from t to t+1: Et FCFtU VEQ . we want to check whether the value Ventity resulting from discounting expected unlevered free cash flows.e. This gives: 19 .t +1 + Dt +1 ) +1 + ( [ ] wt = [ (V EQ . equations (21) and (22)) by computing the weighted average cost of capital at time t.

the covariance ρ. it can be shown that wt can also be represented as a weighted average of the cost of equity and debt. The weighted average cost of capital is the sum of the expected growth rate plus a non-negative adjustment which is a function of the risk-free interest rate. the capital structure. the plowback ratio. we 20 .wt = Et FCFtU +1 + EQt +1 (MBR + ν ) −1 EQt (MBR + ν ) [ ] Since expected book equity grows at a rate of q ROI (see Chapter 3). As it furthermore follows from Equation 6 that ROI (1 + ν )(1 − τ K − q ) + re (τ K − τ S ) + νr f τ K r f − q ROI MBR + ν = this finally gives the WACC: wt = q ROI + rf − q ROI ( ROI (1 + ν )(1 − τ − q ) ) ROI (1 +ν )( 1 − τ − q ) + r (τ − τ ) +νr τ K K e K S f K Equation 8 As can be seen from Equation 8. the weighted average cost of capital is time and state independent. Based on this representation of the WACC. To this end. the market price of risk. we obtain Et FCFtU EQt 1 + q ROI (MBR + ν ) Et FCFtU +1 +1 + −1 = + q ROI EQt (MBR + ν ) EQt (MBR + ν ) EQt (MBR + ν ) wt = [ ] ( ) [ ] Plugging in the respective expressions for the expected cash flow of the unlevered company using Equation 7 yields: EQtU ROI (1 − τ K − q ) (1 + ν )ROI (1 − τ K − q ) = q ROI + wt = q ROI + MBR + ν EQt (MBR + ν ) because EQtU = EQt (1 + ν ) . the expected return on investment. the equity interest rate and the two tax rates.

t = [ VEQ . the WACC as derived in Appendix 5 can be restated as follows: MBR MBR + ν re (τ K − τ S ) ν k E − MBR + MBR + ν r f (1 − τ K ) w= [ ] As equity at market values at each time t is EQt⋅MBR and debt at (both book and) market values at each time t is EQt⋅n. E Et FCFt + 1 + V EQ . The adjustment for the equity tax shields depends on the equity interest rate applied to the stock of equity and the tax differential. The adjustment for the debt tax shields − r f τ K corresponds to that in the well-known textbook formula.t implicitly includes the forward rates kE(s. the WACC is a market value weighted average of the cost of equity and the cost of debt.t +1 k E .2. By introducing the appropriate adjustment for the cost of equity in a world with imputed interest on the stock of equity we extend the existing literature on cost of capital relations generalizing the well-known textbook formula first introduced by Modigliani/Miller (1963). The division by MBR is required due to the fact that equity interest is based on book equity instead of market values.t). derived in Section 5. The cost of equity at time t is the expected return for equity holders over the period from t to t+1. just as the WACC.t = q ROI + Equation 9 Note that the cost of capital kE. 21 . Thus. both adjusted for the value of their respective tax shields.have to calculate the cost of equity first. Equation 9 shows that the cost of equity is independent of time and state. the expression MBR/(MBR+n) is the market value weight of equity and n/(MBR+n) is the market value weight of debt. Using this cost of equity.t ] −1 According to Appendix 4 we can show that: ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) MBR k E .

we derive the WACC in a world with imputed interest on the stock of equity and present the adjustment in the cost of equity which is necessary to allow the computation of the WACC as a weighted average of the cost of equity and cost of debt. Intertemporal differences in systematic risk require the use of various riskadjusted term structures of interest rates in the equity method as well as the APV method. Additionally. The equity method. the discount rates for the valuation of free cash flows and of tax benefits arising from debt and equity financing are derived from the intertemporal evolution of the covariance between book return on investment and the market return. A closed-form solution is derived for the value of equity and that of equity tax shields. we can use the WACC to obtain the value of the firm under the entity method: Ventity = ∑ t =1 ∞ E[ FCFtU ] (1 + w) t Proposition 2: The value of the business under the entity method is the same as the value of the business under the equity method. A proof of Proposition 2 is provided in Appendix 6. a market-to-book ratio comparable to the one resulting from the Gordon constant growth dividend discount model follows. 22 . it is shown that the discount rates appropriate for the equity tax shields equal those for the debt tax shields. 8 Summary This paper integrates a tax regime with imputed interest on the stock of equity into business valuation. Finally. the APV method and the entity method are presented with attention to imputed equity interest. Furthermore.Finally. On the basis of Fama (1977).

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rM . t ) = −1 1 + k (s .t . From Fama's equation (29) in connection with equation (30).t .t = E s [EQt −1 (aROI t + b )] −1 E s −1 [EQt −1 (aROI t + b )] Because EQt-1 and ROIt are uncorrelated.t = = E s [EQt −1 ](aE s [ROI t ] + b ) −1 = E s −1 [EQt −1 ](aE s −1 [ROI t ] + b ) EQs −1 (1 + qROI s ) 1 + q ROI EQs −1 t −s ) (a ROI + b) − 1 = 1 + qROI 1 + q ROI (1 + q ROI ) (a ROI + b) t − s −1 ( s −1 The covariance between εs. so that k (s.APPENDIX Appendix 1: Fama Technology . the two cases s = t and s < t have to be distinguished: For all years s < t: ε s . rM . both on p.s is the return of the market portfolio in period s and εs. rM .t .s. rM.t is an expectations adjustment variable (with zero mean) that measures the incremental information (change in expectation) in period s on the cash flow Zt: E [Z ] ε s . is: cov[ε s . s ] 1 + rf = 1 + rf 1 . 13 in Fama (1977).t and the market return in the same year. s ] = q cov[ROI s .s ] 1 + q ROI = qρ 1 + q ROI so that from Equation 10 26 . ε s . rM . t ) 1 − λ cov[ε s .Discount Rates The goal of this appendix is to derive the discount rates and.t = s t − 1 E s −1 [Z t ] In the derivation of the discount rates for a cash flow stream of the structure Z t = EQt −1 (aROI t + b ) . the forward rates can be derived for a cash flow Zt occurring at time t: 1 − λ cov[ε s . based on this. s ] Equation 10 where rM. the value of a perpetuity of cash flows making use of the Fama valuation model.

k (s . s ] = a cov[ROI t . t ) = 1 + rf a ROI + b a ROI + b − 1 = (1 + r f ) − 1 = (1 + r f ) −1 = aρ a ROI + b − a a ROI − + b λ ρ λρ 1− λ a ROI + b a ROI + b −1 = (1 + r f ) a ROI + b ( ) 27 . rM .t = EQt −1 (aROI t + b ) EQt −1 (aROI t + b ) aROI t + b −1 −1 = −1 = Et −1 [EQt −1 (aROI t + b )] EQt −1 a ROI + b a ROI + b ( ) cov[ε s .t ] a ROI + b = aρ a ROI + b so that from Equation 10 k (s . t ) = 1 + rf 1 + q ROI −1 − 1 = (1 + r f ) qρ q ROI q λρ 1 + − 1− λ 1 + q ROI Now defining ROI = ROI − λρ yields k (s. rM .t . t ) = (1 + r f )1 + q ROI − 1 1 + q ROI For the case s = t we get: ε s .

respectively: ROE = ROI (1 + ν )(1 − τ K ) + re (τ K − τ S ) − νr f (1 − τ K ) ROE = ROI (1 + ν )(1 − τ K ) + re (τ K − τ S ) − νr f (1 − τ K ) By a slight modification of the representation of our market-to-book ratio (Equation 6) we receive ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) r f − q ROI r f − q ROI MBR = = ROE − g rf − g = ROI (1 + ν )(1 − τ K ) + re (τ K − τ S ) − νr f (1 − τ K ) − q ROI = where g = q ROI = q ROI − λρ can be interpreted as risk-adjusted growth rate. Any comparison of the market-to-book ratio from the constant growth dividend discount model with the one in our model requires the specification of the expected return on equity. The return on equity in year t is the ratio of earnings after taxes in year t. EQt-1: ROE t = EATt = ROI t (1 + ν )(1 − τ K ) + re (τ K − τ S ) − νr f (1 − τ K ) EQt −1 To obtain the expected return on equity one has to replace ROIt by ROI or ROI (for the risk-adjusted representation). ( ) 28 . g is the expected growth rate and kE is the cost of equity capital. EATt. and equity at the beginning of year t.Appendix 2: Market-To-Book Ratio Comparison The market-to-book ratio in the Gordon constant growth dividend discount model is: MBR = ROE − g kE − g where ROE is the expected return on book equity. the expected growth rate and the discount rate.

1: VU = EQ0 (1 + ν )ROI (1 − τ K − q ) r f -q ROI The value of the debt tax shields is from Section 6. V0 = EQ0 ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) r f − q ROI [ ] + EQ ν 0 = EQ0 ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) + EQ0ν r f − q ROI r f − q ROI [ ] ( ) The three components from the APV method are as follows: The value of the unlevered business is according to Section 6. resulting in: r f -q ROI ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) + ν r f − q ROI = = ROI (1 + ν )(1 − τ K − q ) + νr f τ K + re (τ K − τ S ) 29 ( ) . we use the fact that the value of the business under the equity method is equal to the value of equity plus the value of debt. cancels out.2: PV (TSD ) = EQ0 νr f τ K r f -q ROI The value of the equity tax shields is (see Section 6.3): PV (TSE ) = EQ0 re (τ K − τ S ) r f -q ROI When these three components are added and then equated to the value of the EQ0 business under the equity method. V0 = V EQ .0 is given by Equation 5 and Dt=nEQt. 0 + D0 As VEQ.Appendix 3: Proof .Proposition (Equivalence of Value from Equity Method and APV Method) In order to demonstrate that the sum of the three components in the APV method corresponds to the value found under the equity method.

Q.E. 30 . the result is: ROI [(1 + ν )(1 − τ K ) − q ] − νq ROI = ROI (1 + ν )(1 − τ K − q ) Factoring out ROI gives ROI (1 + ν )(1 − τ K − q ) = ROI (1 + ν )(1 − τ K − q ) Thus the APV method and the equity method deliver the same results.D.Because all components which contain either the risk-free interest rate rf or the equity interest rate re cancel out.

t VEQ .Cost of Equity: The goal of this appendix is to derive the cost of equity kE.t +1 VEQ .t = EQ Et FCFt + 1 + V EQ .Appendix 4: Derivation .t ] −1 EQ Substituting for FCFt + using Equation 4 and substituting EQtMBR for VEQ.t = EQt ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) MBR EQt MBR [ ] + EQ (1 + q ROI )MBR − 1 t EQt MBR = q ROI + 31 .t +1 [ VEQ .t: k E .t 1 gives after computing the conditional expectation k E .t ] − 1 = E [FCF ] + E [V t EQ t +1 t EQ .

Appendix 5: Proof . this equals w= q ROI ⋅ MBR + ROI [(1 + ν )(1 − τ K ) − q ] MBR + ν Since − q ROI = −q(1 + ν ) ROI + qν ROI . 32 . this is equivalent to w= q ROI ⋅ MBR + qν ROI + ROI (1 + ν )(1 − τ K − q) ROI (1 + ν )(1 − τ K − q) = q ROI + MBR + ν MBR + ν From Chapter 7 we know that MBR + ν = ROI (1 + ν )(1 − τ K − q ) + re (τ K − τ S ) + νr f τ K r f − q ROI Now we can substitute for MBR + n in the equation above: w = q ROI + ROI (1 + ν )(1 − τ K − q ) ROI (1 + ν )(1 − τ K − q ) + re (τ K − τ S ) + νr f τ K r f − q ROI = q ROI + r f − q ROI ( (1 + ν )(1 − τ − q) ) ROI (1 + ν )(ROI 1 − τ − q) + r (τ − τ ) + νr τ K K e K S f K which equals the WACC derived in Equation 8.Representation of WACC as a Weighted Average: The purpose of this appendix is to show that w= MBR MBR + ν re (τ K − τ S ) ν k − + r f (1 − τ K ) E MBR MBR + ν [ ] By rearranging terms w= 1 k E MBR − re (τ K − τ S ) + νr f (1 − τ K ) MBR + ν [ ] In a first step we substitute Equation 9 for kE and rearrange terms: w= 1 q ROI ⋅ MBR + ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) − re (τ K − τ S ) + νr f (1 − τ K ) MBR + ν [ ] As both terms re (τ K − τ S ) cancel out and the same is true for the both terms νr f (1 − τ K ) .

33 .E.D.Q.

Thus. the expected free cash flows of the unlevered business are a growing perpetuity with E[ FCF1U ] = EQ0 (1 + ν ) ROI (1 − τ K − q ) and a growth rate of q ROI : Ventity = EQ0 (1 + ν ) ROI (1 − τ K − q) w − q ROI Substituting for w as derived in Equation 8 yields EQ0 (1 + ν ) ROI (1 − τ K − q ) ROI (1 + ν )(1 − τ K − q ) + re (τ K − τ S ) + νr f τ K ROI (1 + ν )(1 − τ K − q )(r f − q ROI ) Ventity = [ ] As ROI (1 + ν )(1 − τ K − q) cancels out. the growth rate of EQtU −1 ROI t ( equals that of EQt. From Equation 7 we know that the free cash flows of the unlevered business are FCFtU = EQtU 1 − τ K − q ) .0 + D0. The value of the firm under the entity method is Ventity = ∑ t =1 ∞ E[ FCFtU ] (1 + w) t . this results in 34 . As EQtU = EQt (1 + ν ) .Appendix 6: Proof – Proposition 2 (Equivalence of Value from Entity Method and Value from Equity Method) The purpose of this appendix is to show that Ventity = VEQ. this is equivalent to EQ0 ROI (1 + ν )(1 − τ K − q) + re (τ K − τ S ) + νr f τ K r f − q ROI Ventity = [ ] As − EQ0 ROI (1 + ν )q = − EQ0 ROI q − EQ0νq ROI and EQ0νr f τ K = − EQ0νr f (1 − τ K ) + EQ0νr f .

E.D.Ventity = EQ0 ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K )] + EQ0ν (r f − q ROI ) EQ0 ROI [(1 + ν )(1 − τ K ) − q ] + re (τ K − τ S ) − νr f (1 − τ K ) r f − q ROI [ ] = [ r f − q ROI ] + EQ ν 0 From Equation 5 and the fact that D0 = EQ0n we see that Ventity = VEQ . 0 + D0 Q. 35 .

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