Journal of Financial Economics 15 (1986) 323-339.

North-Holland

CALCULATING THE MARKET VALUE OF RISKLESS CASH FLOWS

Richard S. RUBACK*
Massachusetts Institute of Technology, Cambridge, MA 02139, USA

Received September 1983, final version received July 1985

This paper uses arbitrage arguments to calculate the market value of riskless after-tax cash flows.
The market value equals the present value of riskless after-tax cash flows discounted at the
after-corporate-tax riskless interest rate. The market value equals the adJusted present value of
riskless after-tax cash flows only when the incremental debt used in the adjusted present value
calculations equals the market value of the remaining after-tax cash flows. Also, the analysis
provides valuation formulas when interest and tax rates are certain but not uniform and when
interest rates are uncertain.

1. Introduction

This paper examines a fundamental valuation question: How should the

market value of a stream of riskless after-tax cash flows be calculated? The
market value of a stream of riskless after-tax cash flows is defined as the
minimum amount of money that has to be invested in riskless securities to
replicate the cash flows. Cash flows are defined as riskless when the realization
of the cash flows are (1) certain, (2) do not depend on the actions of the firm,
and (3) do not depend on the identity of the claimant. Two well-known
alternative techniques appear to provide the market value of a stream of
riskless after-tax cash flows: the present value technique and the adjusted
present value technique.
The present value of a stream of riskless after-tax cash flows is calculated by
discounting them at an appropriate cost of capital. The present value technique
is, however, incomplete since it does not specify the appropriate cost of capital.
Reasonable choices for such a cost of capital range from the before-tax riskless
interest rate, r, to the after-corporate-tax interest rate, r(1 - r), where 7 is the
corporate tax rate. Arguments for using the before-tax riskless interest rate
typically equate the investors opportunity cost of capital with the corporations

*I would like to thank the participants of seminars at M.I.T. and the University of Oregon. I
would also like to thank Fischer Black, Paul Healy, Robert Merton, Wayne Mikkelson, Stewart
Myers, John Parsons, and especially John Long (the referee) and Michael Jensen for comments on
earlier drafts of this paper. This research was completed while I was a Batterymarch Fellow and I
thank Batterymarch Financial Management for financial support.

0304-405X/86/$3.500 1986, Elsevier Science Publishers B.V. (North-Holland)

324 R. S. Rubuck. The market value of riskless cashjows

cost of capital: since investors can earn the riskless interest rate by directly
investing in riskless bonds, the after-corporate-tax earnings on riskless corpo-
rate investments must equal or exceed the before-tax riskless interest rate to
compensate investors for their opportunity cost of capital. In contrast, argu-
ments for using a tax adjusted discount rate focus on the deductibility of
interest payments from taxable corporate income: the after-tax cost of riskless
debt to a corporation is the risklcss rate, r, less the interest tax shield, rr.
The second technique to calculate the market value of a stream of after-tax
riskless cash flows is the adjusted present value approach recommended by
Myers (1974) and Brealey and Myers (1984). In the adjusted present value
approach, the market value of a stream of riskless after-tax cash flows is the
sum of two components:

T x,(1 -7) rrDr

APV= c +&-
1-1 (l+r) r=* (1+r)

The first term on the right-hand side of (1) is the after-tax cash flows,
X,(1 - r), discounted at the before-tax interest rate. The second term on the
right-hand side of (1) is the interest tax shields, rrD,, that accrue from the
incremental debt, D,, supported by the project in each period discounted at
the before-tax interest rate. The adjusted present value approach, however, is
incomplete because it does not specify how much debt is supported by a
riskless project.
This paper uses arbitrage techniques to calculate the market value of a
stream of riskless after-tax cash flows. It resolves the issue of whether the
before-tax or after-tax riskless interest rate should be used in the present value
technique by showing that the market value equals the present value of the
riskless after-tax cash flows discounted at the after-corporate-tax riskless interest
rate. It also resolves the issue of how much debt should be included in the
adjusted present value calculations by showing that the market value equals the
adjusted present value of the riskless after-tax cash flows only when the
incremental debt used in the adjusted present value calculations equals the market
value of the remaining riskless after-tax cash flows.
The arbitrage approach formalizes the standard conceptual definition of the
market value of a stream of cash flows: the market value of a stream of riskless
cash flows is the minimum amount of money that has to be invested in riskless
securities to replicate the stream of riskless after-tax cash flows. Specifically,
the firm constructs an arbitrage by issuing riskless debt with after-tax pay-
ments that exactly offset the stream of riskless after-tax cash flows being
valued. The proceeds from issuing the offsetting debt equal the present value of
the after-tax debt payments discounted at the after-corporate-tax riskless
interest rate. The after-corporate-tax riskless interest rate is the appropriate
 R. S. Ruhack, The market value of riskless cash jlow 325

cost of capital because interest payments on the offsetting debt are deductible
from the firms taxable income. Since the after-tax payments on the offsetting
debt equal the riskless after-tax cash flows being valued, the proceeds from
issuing the offsetting debt equals the market value of the riskless after-tax flow.
Therefore, the market value of the stream of riskless after-tax cash flows equals
the present value of the riskless after-tax cash flows discounted at the after-cor-
porate-tax riskless interest rate.
Henderson (1976) also shows that the market value of riskless after-tax cash
flows equals their present value discounted at the after-corporate-tax riskless
interest rate. However, his results depend on the assumptions of the tax-cor-
rected Modigliani and Miller (1963) theory of capital structure - including the
absence of personal taxes and the independence of financing decisions and
other corporate policies such as investment decisions. In contrast, the arbitrage
approach used in this paper involves no such restrictions.
Myers (1974) recognizes that the incremental debt of the adjusted present
value approach could be related to the projects market value. But he did not
show that the debt capacity of a riskless project equals its market value in each
period. He proposes a dynamic programming solution in which the projects
debt capacity is assumed to be proportional to the projects adjusted present
value in each period. Myers, Dill and Bautista (1976) use the dynamic
programming approach in their application of the adjusted present value
technique to leasing. They show that the after-tax cash flows associated with
riskless lease financing should be valued by discounting them at the after-cor-
porate-tax riskless interest rate. Also, Franks and Hodges (1978) use arbitrage
arguments similar to those used in this paper to show that the after-tax cash
flows associated with riskless lease financing should be valued using the
after-corporate-tax riskless interest rate. Both Myers, Dill and Bautista (1976)
and Franks and Hodges (1978) use the similarity between financial leases and
debt to argue that leasing displaces debt so that it is appropriate to value the
net cash flows associated with leasing as a form of debt.
The arbitrage proof in this paper shows: (1) that the incremental debt
supported by any riskless after-tax cash flow equals the market value of the
after-tax cash flow, and (2) that the appropriate discount rate for any riskless
after-tax cash flow is the after-corporate-tax riskless interest rate. Also, the
analysis in this paper provides valuation formulas when interest and tax rates
are certain but not uniform and when interest rates are uncertain.
In a capital budgeting context, the techniques developed in this paper are
used to estimate the market values of the riskless after-tax cash inflows and
outflows from a project. Projects increase the market value of the firm when
the market value of the after-tax inflows exceeds the market value of the
after-tax outflows. The arbitrage valuation technique ensures that projects
which increase the market value of the firm are self-financing because the
proceeds from issuing the offsetting debt are more than sufficient to finance the
326 R. S. Rubuck, The market value of riskless cushjlow

riskless after-tax cash outflows. Projects which leave the market value of
the firm unchanged are exactly self-financing because the market value of the
riskless after-tax inflows and outflows are equal.
In section 2, I show that, when interest and tax rates are constant and the
firm realizes the full value of its interest tax shields, the market value of a
single riskless after-tax cash flow is determined by discounting it at the
after-corporate-tax riskless interest rate. Section 3 presents two extensions.
First, when interest rates and marginal tax rates are certain, but not constant
over time, the market value of a riskless after-tax cash flow is calculated by
discounting the riskless after-tax cash flow by the period-by-period after-corpo-
rate-tax interest rates which are determined by market interest rates and the
firms marginal tax rates. Second, when future one-period interest rates are
uncertain and the tax rates are constant, the market value of riskless cash flows
can be determined using the after-corporate-tax yields to maturity calculated
from current pure discount bond prices and the firms tax rate. Section 4 shows
that the market value of a riskless after-tax cash flow can be calculated using
the adjusted present value approach when the incremental debt used in the
calculations equals the market value of the after-tax riskless cash flow in each
period. Section 5 discusses the valuation of streams of riskless after-tax cash
flows, and section 6 concludes the paper.

2. The market value of a single riskless cash flow when interest and tax rates
are constant

Proposition. If ajrm realizes the full value of its interest tax shields, the market
value of a single riskless after-tax cash flow is determined by discounting it at the
after-corporate-tax riskless rate of interest.

Proof. Suppose a firm is going to receive a single riskless cash flow of X, in T

periods, The firm pays taxes equal to the corporate tax rate, 7, times the cash
flow so that the after-tax cash flow is X,(1 - 7). To offset the riskless cash
inflow with a riskless cash outflow the firm constructs the offsetting debt as
follows: In the initial period the firm borrows B,. In the next period the firm
repays B,(l + r) to retire its debt. It can finance this repayment with a new
loan of B, = B,(l + r(1 - T)) because the remainder, 7rB0, is paid from the
realized interest tax shield. The realized interest tax shield is the reduction in
taxes paid that occurs because taxable income is reduced by the interest
payment, rB,. This rollover process continues in each period prior to period T.
Thus, in period t the firm repays the face value of its debt from the prior
period, B,_i(l + r), with its interest tax shield TrlIpl and a new loan of
B, = B,_ i(l + r(1 - 7)).
 R. S. Ruhack, The marker value ofnsklesscashflows 321

The initial amount borrowed, B,, is determined so that the loan from period
T - 1 is repaid in period T with the after-tax cash flow, X,(1 - T), and the tax
shield rrB,_,. In period T,

X,(1 - T) = B,p,(l + r) - T~B~_~ = B,_,(l + r(1 - 7)).

Since the loan is refinanced each period,

B,= B,_,(l + r(1 -T)),

and, by recursive substitution,

X,(1 - 7) = B,(l + r(1 - 7)).

Rearrangement provides

B = M-4
(l+r(l-T))T'

Thus B, is the present value of the after-tax riskless cash flow, X,(1 - T),
discounted at the after-corporate-tax riskless interest rate, r(1 - T). This
present value is defined as PV( X,(1 - T)),

&-0 - T>
Pv(x,(l -T)) =B,=
(1 + r(l -T))

Since the only net cash flow from the riskless after-tax cash inflow of
X,(1 -T) and the offsetting debt is B,, the initial amount borrowed, the
present value of X,(1 - T) equals the market value of the riskless after-tax
cash flow. Therefore, the market value of a single after-tax cash flow is
obtained by discounting it at the after-corporate-tax riskless interest rate. This
discounting procedure provides the market value of any after-tax riskless cash
flow including depreciation tax shields, income subject to capital gains treat-
ment and non-taxable proceeds from asset sales. To apply the proposition to
these cash flows, the numerator in (2) X,(1 - T), is replaced by the after-tax
riskless cash flow being valued.
The market value of the riskless cash flow is obtained by constructing an
arbitrage in which the after-tax payments on the offsetting debt exactly offset
the after-tax cash flow being valued. Therefore, the market values of the
riskless after-tax cash flow and the offsetting debt are equal in each period.
Assuming that the riskless after-tax cash flow is the only collateral for the
offsetting debt and that, upon default, lenders would receive the riskless
328 R. S. Ruhuck, The murket due of riskless tush jaws

after-tax cash flow, this time profile of borrowing is the maximum self-
enforcing loan contract, that is, the maximum amount the firm can borrow in
each period at the riskless interest rate. If the market value of the offsetting
debt exceeds the market value of the riskless cash flow in any period, the firm
has the incentive to default on its loan contract and the offsetting debt would
not be riskless. No such incentive to default occurs with the debt that exactly
offsets the riskless after-tax cash flow. While the firm could borrow less than
amounts required to offset the riskless after-tax cash flow at the riskless interest
rate, borrowing the full market value of the riskless after-tax cash flow in each
period maximizes the value of the interest tax shields.
Borrowing the full market value of the project also eliminates changes in the
amount of net riskless debt which would otherwise be associated with the
project, where net riskless debt is defined as the.market value of riskless cash
outflows less the market value of riskless cash inflows. If the firm did not issue
the offsetting debt, taking the project would decrease the amount of net riskless
debt by the market value of the riskless after-tax cash flow and thereby change
the capital structure associated with the firms pre-existing assets. Since the
market value of the offsetting debt equals the market value of the project, a
firm that takes the project and issues the offsetting riskless debt does not
change the capital structure associated with its pre-existing assets. Therefore,
the valuation consequences of project induced capital structure changes is
properly ignored.
The arbitrage proof values riskless after-tax cash flows. Cash flows are
defined as riskless when the realization of the cash flows are (1) certain, (2) do
not depend on the actions of the firm, and (3) do not depend on the identity of
the claimant. Assuming that the project is the only collateral for the debt,
lenders will be unwilling to lend the firm the full market value of the after-tax
cash flows at the riskless interest rate when the after-tax cash flows are certain,
but do not satisfy the second and third conditions. The second condition can
be violated when the firm has the opportunity to alter the timing of cash flows.
For example, the firm may be able to shift cash inflows forward in time. After
such a shift, the market value of the debt payments that offset the original cash
flows will exceed the market value of the remaining cash flows for the project.
If the project is the only collateral for the offsetting debt, the firm will have an
incentive to default. The third condition is violated when the project will
generate lower after-tax cash flows for the lenders than it would for the firm.
When the firm cannot borrow the full market value of the after-tax cash flow
on a non-recourse basis, one simple solution is for the firm to pledge additional
collateral to the lenders. However, the costs of pledging additional collateral
reduce the value of the project, and therefore the valuation techniques pre-
sented in this paper cannot be literally applied.
The arbitrage proof focuses on a portfolio of offsetting debt because the
riskless interest rate is readily observable. However, the portfolio of offsetting
 R. S. Ruback, The market value of riskless cash &vs 329

securities could also be constructed by issuing riskless equity. The relative

proceeds from offsetting the riskless after-tax cash flow with riskless debt or
riskless equity depends on the corporate tax advantages to debt financing. If
there are corporate tax advantages to debt financing, the proceeds from a
portfolio of offsetting securities constructed with riskless debt will be higher
than an offsetting portfolio constructed with riskless equity. If there are no
corporate tax advantages or disadvantages to debt financing, as in Millers
(1977) model, the market value of the stream of riskless cash flows is unaffected
by constructing the portfolio of offsetting securities using riskless debt or
riskless equity.

3. Extensions

3. I. Non-uniform certain interest and tax rates

Changes in interest rates can be incorporated into the analysis by using pure
discount bonds to offset the cash flows being valued. If future one-period
interest rates are certain, the offsetting debt is constructed by rolling over
one-period discount bonds. Similarly if future tax rates are non-uniform but
certain, the offsetting debt is constructed using the realized interest tax shields.
In particular, the offsetting debt is constructed as follows: In the initial period
the firm borrows B,. In the next period the firm repays the outstanding debt
with its realized interest tax shield of T1rlBO and a new loan of

B, = B,(l + t-,(1-TV)),

where 7t and rl are the tax and interest rates in period 1. This rollover process
continues in each period prior to period T. That is, in each period t, the firm
repays the face value of its loan from the prior period, B,_,(l + r,), with the
realized interest tax shield of r,rl B,_ 1 and a new loan of B, = B,_r(l + r,(l - 7,)).
The face value of the offsetting debt in period T is B,-,(l + rT). By recursive
substitution,

T-l

BT-10+ rT) = 0 + r,)Bo JTj(1+ r,(l - 3)).

Again, the initial amount borrowed, B,, is determined by equating the

required repayment of the face value of the offsetting debt in period T to the
after-tax riskless cash flow of X,(1 - 7T) plus the realized interest tax shield of
7rrTBr_ r:
330 R. S. Rubark, The market value of riskless cmhJlows

and substituting from (3) for B,_,(l + rr) provides

T-l
(1 + +4, I-I (I+ rt(l - 7,))
f=l

T-1
= X,(1 - TV) + 7yrB, n (1 + r,(l - 7,)).
r=1

Collecting terms,

XT0 - 4 = Bo,f!
cl+ r,(l - TJ>. (4)

Thus, since the initial amount borrowed, B,, accrues to X,(1 - To), rearrang-
ing (3) shows that the market value of X,(1 - TV) with non-uniform but
certain interest and tax rates equals the present value of the riskless after-tax
cash flow discounted at the period-by-period after-corporate-tax riskless inter-
est rates:

h-(1 - 5-1
Pv( x,(1 - TT)) = B, = T
(5)

3.2. Uncertain interest rates

If future one-period interest rates are uncertain and the tax rates are certain,
the firm can use the current prices of multiple-period pure discount bonds to
value the after-tax cash flow. The firm offsets the after-tax cash flow being
valued by short selling pure discount bonds and the proceeds from these short
sales is the market value of the after-tax cash flow. Short selling pure discount
bonds is, of course, equivalent to borrowing. While the firm could negotiate a
loan to offset the riskless after-tax cash flow, I assume that the borrowing
occurs by short selling pure discount bonds to emphasize that the arbitrage
valuation approach is based upon observable security prices.2
Suppose the firm is going to receive a single riskless after-tax cash flow of
X,(1 - T) in T periods and that taxable income is sufficiently high in each
period so that the firm realizes the full value of its interest tax shields. The

The arbitrage technique cannot be used to value cash flows when tax rates are uncertain unless
traded securities exist which enable the firm to hedge the tax rate uncertainty.
2Multiple-period pure discount bond prices can be deduced from the market prices of coupon
bonds. In practice, however, it may be difficult to obtain the required pure discount bond prices,
especially for long-lived projects, because of the limited set of available riskless coupon bonds.
 R. S. Ruback, The market value ojriskless cash flows 331

corporate tax rate is assumed to be constant and equal to r in each period.

Since interest rates are uncertain, the firm cannot construct the arbitrage
portfolio by rolling over one-period pure discount bonds. Instead, the entire
arbitrage portfolio is constructed in the initial period by short selling a series of
pure discount bonds of various maturities. The offsetting debt consists of a
portfolio of pure discount bonds of various maturities because the tax code
allows the firm to deduct the interest on the accrued loan balance in each
period. That is, in period t the firm is allowed to deduct interest of B,R,(l +
R r)- where B, is the initial amount of bonds sold short and R T is the yield
on a pure discount bond that matures in period T. Therefore, the T-period
pure discount bond which is sold short to offset the after-tax cash flow which
occurs T periods hence creates interest tax shields in period 1 through T. The
interest tax shields in periods 1 through T - 1 are offset by short selling
additional pure discount bonds which in turn create tax shields that must be
offset to complete the arbitrage portfolio. This feature of the tax code,
therefore, necessitates the introduction of additional notation: define Z, as the
dollar amount of pure discount bonds that are sold short to offset the cash flow
in period t.
The dollar amount of pure discount bonds sold short to offset the after-tax
cash flow that occurs in time T, Z,, is determined by equating the outflow in
period T, Z,(l + R,), to the inflows in period T:

Z,(l + R,)T= X,(1 -T) + 7Z,R,(l + R,)T-l,

where the outflow, Z,(l + R,)T, is the face value of the maturing debt, R, is
the yield on the pure discount bond that pays one dollar at time T, and the
after-tax inflows are the assumed riskless after-tax cash flow, X,(1 - T), plus
the interest tax shield on the debt that matures in period T, 7Z,Rr(l + R,J~-.
Rearrangement yields

z,=
XT0 - 4
(1 + R,)r-(1 + R,(l - 7)) .

However, as discussed above, the pure discount bond that matures in period
T creates interest tax shields (positive after-tax cash inflows) in each inter-
mediate period. The firm offsets these intermediate interest tax shields by short
selling pure discount bonds that mature in the period that the interest tax
shields are realized. For example, in period T - 1 the firm receives an interest
tax shield of 7Z,R.(l + R,)Tp2 from the pure discount bonds that mature in
period T and an interest tax shield of TZ~_ 1R,- i(l + R,_ 1)T-2 from the
bonds that mature at T - 1. The amount of bonds sold short to offset these
positive cash flows in period T - 1, Z,_,, is again determined by equating
332 R. S. Ruhuck, The market value of riskless cash flows

inflows and outflows:

Z&l + RT_l)T-l = TZ&(l+ R,y2

+rz r_,R,_,(l + R,_JTP2.

Rearrangement yields

TZ,&(l+ R.)T-2
Z
T-1= (1 + R._,)rP2(1 + R,_,(l - 7))
(7)

The bonds that mature in periods T and T - 1 provide interest tax shields in
period T - 2 which are offset by short selling discount bonds that mature in
T - 2 in an amount given by

TZ,R,(l+ R,)T-3 + TZ,_,R,_,(l + R,_JTP3

Z r-2= (8)
(1+ R._,)rP3(l + R,_,(l - 7))

The general expression for the amount of pure discount bonds that are sold
short to offset the interest tax shields realized in period T - K is

7 ,F, ZT-,RT-ru + LtrK-

Z (9)
TpK= (1+ R,_K)T-KP1(l + R,_,(l - 7))

for K= 1,2 ,..., T- 1.

The portfolio of pure discount bonds constructed using (6) through (9)
provides two non-zero cash flows: a positive cash flow in the initial period that
equals the proceeds of the short sales, and a negative cash flow in period T
that exactly offsets the riskless after-tax cash flow being valued. Therefore, the
market value of the riskless after-tax cash flow, MV( X,(1 - T)), is the pro-
ceeds from the borrowing created by the short sales:

MV( x,(1 - 7)) = i z,. (10)

f=l

It is feasible for the firm to create the portfolio of short sold pure discount
bonds of different maturities to offset the after-tax riskless cash inflow,
X,(1 - 7). and the series of after-tax cash flows created by the interest tax
 R. S. Rubuck, The murket unlue of riskless cash flows 333

shields. The offsetting debt is the maximum self-enforcing loan that the firm
can fully secure with the riskless after-tax cash flow from the project and the
riskless interest tax shields. As in the case of certain riskless interest rates
described in section 2, this feature of the offsetting debt results from the fact
that the market value of the riskless after-tax cash flow and the offsetting debt
are equal in each period. When interest rates are uncertain, the portfolio of
offsetting debt is constructed in the initial period using the yields implicit in
current pure discount bond prices to exactly offset the riskless after-tax cash
inflow. The proceeds from issuing the offsetting debt equals the market value
of the project in the initial period. Since the after-tax inflow from the project
and the after-tax outflow from the debt are identical in all future periods,
interest rate changes will affect the market values of the offsetting debt and the
project equally. Thus, the market value of the offsetting debt and the project
will be equal in each period. Since lenders would receive the riskless after-tax
cash flow upon default, the firm will have no incentive to default on the
offsetting debt. Also, since all cash flows associated with the project are offset,
there is no change in the amount of net riskless debt, which is the market value
of riskless cash outflows less the market value of riskless cash inflows.
Table 1 presents an example of this arbitrage valuation procedure for a
riskless after-tax cash flow of $100 that occurs three periods hence. The firms
tax rate is 50% and the annual yield on a one-period pure discount bond is
lo%, the annual yield on a two-period pure discount bond is 20%, and the
annual yield on a three-period pure discount bond is 30%. The dollar amount
of three-period pure discount bonds that are sold short to offset the $100
riskless after-tax cash flow that occurs in period 3 is $51.45, which is de-
termined using (6). In period 3 the firm must repay the face value of the
three-period pure discount bond, $51.45(l.3)3, which equals $113.04. The
interest tax shield in period 3 is (0.5)(0.3)(51.45)(l.3)2, which equals $13.04.
Thus the $113.04 payment on the three-period pure discount bond net of the
$13.04 interest tax shield exactly offsets the $100 after-tax riskless cash flow
from the project. The three-period pure discount bond also generates interest
tax shields of $7.72 in period 1 and $10.03 in period 2. As shown in table 1, the
interest tax shield of $10.03 in period 2 is offset by selling short $7.60 of
two-period pure discount bonds (determined using (7)). In period 1, the
interest tax shields from the three-period pure discount bond and the two-period
pure discount bond total $8.48. This is offset by short selling $8.07 of
one-period pure discount bonds [calculated using (S)].
The arbitrage portfolio, which contains $51.45 of three-period pure discount
bonds, $7.60 of two-period pure discount bonds, and $8.07 of one-period
discount bonds, offsets the riskless after-tax cash flow of $100 from the project
and the interest tax shields in each period. Therefore, the market value of the
riskless after-tax cash flow equals the proceeds from the short sales, $67.12.
Note that the market value does not equal the $65.75 present value of the $100
334 R. S. Ruhack, The murket value of risklesscushjlows

Table 1
Annual after-tax cash flows for an arbitrage valuation example. The project being valued has an
after-tax riskless cash flow of $100 in the third period. The firms tax rate is 50% and the yield on a
one-period pure discount bond is 108, the yield on a two-period pure discount bond is 20%, and
the yield on a three-period pure discount bond is 30%.

Year
0 1 2 3

After-tax riskless
cash flow $100
Three-period pure
discount bond $51.45 $1.12 $10.03 ~ 100
Two-period pure
discount bond 7.60 0.76 - 10.03b
One-period pure
discount bond 8.07 - 8.48

Total $67.12 $0 $0 $0

The face value of the $51.45 of three-period pure discount bonds sold short is $51.45(1.3) =
$113.04 in period 3. The interest tax shield from these bonds in period 3 is $51.45(0.5)(0.3)(1.3)2 =
$13.04. The after-tax payment in period 3 to repay the three-period pure discount bonds that are
short sold is $100, which is the face value less the interest tax shield.
The face value of the $7.60 of two-period pure discount bonds short sold is $7.60(1.2)2 = $10.94
in period 2. The interest tax shield for these bonds in period 2 is $7.60(0.5)(0.2)(1.2) = $0.91. The
after-tax payment in period 2 to repay the two-period pure discount bonds that are sold short is
$10.03 which is the face value less the interest tax shield.
The face value of the $8.07 of one-period pure discount bonds sold short is $8.07(1.10) = $X.88
in period 1. The interest tax shields for these bonds in period 1 is $8.07(0.5)(0.10) = $0.40. The
after-tax payment in period 1 to repay the one-period pure discount bonds that are short sold is
$X.48, which is the face value less the interest tax shield.

riskless after-tax cash flow discounted at the 15% after-tax yield to maturity on
the three-period pure discount bond. Thus, the simple notion often implied by
textbook discounting procedures fails when interest rates are not constant
because the intermediate tax shields from the offsetting debt should be
discounted at yields relevant to the periods in which the tax shields are
realized.

4. The adjusted presence value approach

Myers (1974) and Brealey and Myers (1984) suggest the adjusted present
value approach as an alternative to incorporating the tax deductibility of
interest into the discount rate. In the adjusted present value approach, a single
riskless after-tax cash flow is valued as the sum of two components: the
after-tax cash flow discounted at the before-tax interest rate and the interest tax
shields that are generated from the incremental debt supported by the project
discounted at the before-tax interest rate.
 R. S. Rubuck, The market due of riskless cash flows 335

When interest rates are uncertain, the market value of a single riskless
after-tax cash flow equals the proceeds at time 0 from short selling an offsetting
portfolio of discount bonds which is given by (10). Eq. (10) can be rearranged
in the adjusted present value format as follows:

i: &ZK(l + I?,)_
x,(1 -4 T [
Kzr I
MVX,(1-4=(l+R )r+ c (11)
T t=1 (1+Q .

The first term on the right-hand side of (11) is the riskless after-tax cash flow
discounted at the before-tax yield on a T-period pure discount bond. The
bracketed summation in the numerator of the second right-hand side term of
(11) is the interest tax shield associated with the pure discount bonds that are
outstanding in period t. For example, in period 2 interest tax shields are
generated by the bonds that mature in periods 2 through T. The interest tax
shield on each of these bonds is the product of the tax rate, 7, the yield on the
bond, R,, and the accrued balance, Z,(l + RK). The second right-hand-side
term of (11) therefore, equals the sum of the interest tax shields in each period
discounted at the corresponding before-tax yield. Thus, expression (11) shows
that the market value of a single riskless after-tax cash flow can be calculated
as the sum of the after-tax cash flow discounted at the before-tax rate plus the
interest tax shields in each period discounted at the corresponding before-tax
rate.
Expression (11) shows that the adjusted present value approach is equivalent
to the arbitrage valuation in (10) when, in each period, the incremental debt
supported by the project equals the market value of the offsetting debt. For
example, when interest rates are constant, eq. (11) simplifies to3

XT0 - T> 7TVtT 1

MV(X,(l-7))= v;= +&- (12)

(1 +r)T ,=I (1-t r)[

3 When interest rates are constant, the yield to maturity on pure discount bonds of any maturity
equals the one-period riskless interest rate, r. Substituting the constant riskless interest rate for R,
in first term on the right-hand side of (11) provides the first term on the right-hand side of (12).
Replacing the various yields in the second right-hand-side term of (11) with the constant mtereat

(a)
rate, r. provides

r-1
+L

The bracketed
(1 +r) [
(1 + r)[+ i
1=K
z,
1
term in (a) can be simplified by noting that the expression for Z,. eq. (6). becomes
&(1-r)
z,= (b)
(1 + ,)rm(l + r(1 -r))
when interest rates are constant. Also, the expression for Z,. t. eq. (7). becomes
rrZ,(l + r)Jm2
Z
r- = (1 + ,)r-2(1 + r(l -r)) =Zr[ 1 +r;:-r)]
336 R. S. Ruhack, The market value of riskless cushjowows

where
XT0 - 7)
v,= (13)
(1 + r(l - 7))T-.
The second term on the right-hand side of (12) is the sum of the interest tax
shields from the offsetting debt discounted at the before-tax interest rate. The
market value of the offsetting debt in each period, V,T1, equals the market
value of the riskless after-tax cash flow at the beginning of the period. Note
that the market value is calculated using the present value technique (2) by
discounting the after-tax cash flow at the after-tax interest rate and thereby
includes the value of the interest tax shields that are associated with the
project.
Brealey and Myers (1984, p. 412) recommend adjusting the second right-hand
term of (12) for differences between the effective corporate tax rate on interest
and the firms marginal tax rate. The effective corporate tax rate on interest
includes the effects of differences in the personal tax rates for interest and
equity income. For example, in the tax neutral equilibrium posited by Miller
(1977), the effective corporate tax rate on interest is zero. The adjustment
recommended by Brealey and Myers would eliminate the second right-hand
term of (12) when the effective corporate tax rate on interest is zero. However,
the arbitrage approach shows that such an adjustment will result in an
incorrect measure of the market value of riskless after-tax cash flows. The

Therefore,

Similarly,
1+r
z,+z,_,+z,_,= *+r(l_r)(Zr+Z,w)=Zr

This recursive substitution implies that

Substituting the expression for Z, in (b) into (c) yields

X,(1 -7)
= (1 + r)_(l + r(1 - #-+I

Thus, the bracketed term in (a) equals

(4
which is the present value of Z,(l ~ T) in period t ~ 1, which is defined in (13) as V,,,
Substituting expression (d) for the bracketed expression in (a) provides the second right-hand-side
term of (12).
 Table 2
Examples of adjusted present value calculations for a project that provides a single after-tax cash flow of $100 in the third period. The before tax
interest rate (r) is 20% and the tax rate (7) is 50%. The market value of the after-tax cash Row is lOO/(l + r(l - 7))3 = $75.13.

E.xumple A Example B Example C

Debt equals the Debt equals the Debt equais the after-
after-tax cash after-tax cash tax cash flow discounted
flow discounted how discounted at the after-tax
at the after-tax at the before- interest rate initially
interest rate in tax interest rate and is repaid in three
each period in each period equal installments

Time Beginning Interest Beginning Interest Beginning Interest

period balance tax shield balance tax shield balance tax shield
1 $75.13 $7.51 $57.87 $5.79 $75.13 $7.51
2 R2.64 8.27 63.66 6.37 54.49 5.45
3 90.90 9.09 70.02 7.00 29.72 2.97
~~
Periods 1.2, and 3
interest
tax shields $17.26 $13.30 $13.56
discounted
at 20%

Period 3 $100
cash flow
discounted 57.87 57.87 57.87
at 20%

Total 75.13 71.17 71.43

-- .,.__.
.,, ,_, - I
-, - _. .,,
33x R. S. Ruhuck, The mark& mdue of riskless tush _fbws

adjusted present value approach, as expressed in (12) and (13) provides the
market value of riskless after-tax cash flows for any structure of personal tax
rates because this structure is incorporated into the riskless interest rate.
Table 2 contains three examples of adjusted present value calculations for a
hypothetical project that has a single riskless after-tax cash flow of $100 three
periods hence. The riskless interest rate is assumed to be 20% and the tax rate
is 50%. According to the present value technique (2) the market value of this
project is the after-tax cash flow of $100 discounted at the 10% after-corporate-
tax interest rate which equals $75.13. Example A illustrates that the adjusted
present value approach correctly values the project when the projects debt
equals the market value of the after-tax cash flow in each period. Other
measures of the projects debt will not lead to the correct valuation of the
project. For instance, example B of table 2 contains the adjusted present value
calculation when the projects debt equals the iiskless after-tax cash flow
discounted at the before-tax interest rate. In this case, the adjusted present
value approach does not correctly value the project because not enough debt is
included in the calculations. In example C of table 2 the correct amount of
debt is borrowed in the initial period. But instead of increasing at the after-tax
interest rate as in example A, the debt is repaid in three equal installments so
that its market value declines over time. Since the projects debt does not equal
the market value of the after-tax cash flow in each period, the adjusted present
value technique does not provide the correct market value for the project.
In summary, the adjusted present value approach correctly values a riskless
after-tax cash flow when the debt used in the calculations equals the market
value of the portfolio of bonds that are sold short to offset the riskless after-tax
cash flow in each period. The market value of this offsetting debt equals the
market value of the after-tax cash flow in each period. When interest rates are
constant, determining the market value of a riskless after-tax cash flow by
discounting it at the after-tax interest rate using (2) is much easier than the
adjusted present value approach (12). To use the adjusted present value
approach, the market value of the cash flow in each time period has to be
calculated to determine the appropriate interest tax shields. These interest tax
shields and the after-tax cash flow are then discounted to obtain the market
value. In contrast, the present value approach provides the market value of
riskless after-tax cash flows directly. However, when interest rates are uncer-
tain, discounting at the after-tax yields using (10) appears to be as difficult as
the adjusted present value approach (11) since both approaches require con-
struction of the offsetting portfolio of pure discount bonds.

5. Valuing streams of cash flows

The valuation formulas presented in sections 2, 3 and 4 apply to a single
riskless after-tax cash flow. These formulas can be easily extended to value a
 R. S. Ruback, The market value ojriskle~~ cash flows 339

sequence of riskless after-tax cash flows. Since market values are additive, the
market value of a sequence of cash flows is the sum of the market values of the
individual cash flows in the sequence. In other words, the appropriate val-
uation formula is used to value each after-tax cash flow and the sum of these
values equals the market value of the sequence of after-tax cash flows.

6. Summary

This paper uses arbitrage arguments to calculate the market value of riskless
after-tax cash flows when the riskless interest rate and corporate tax rate are
constant, when riskless interest rates and corporate tax rates are certain, but
not constant over time, and when riskless interest rates are uncertain and tax
rates are constant over time. In the analysis, the firm constructs a portfolio of
offsetting debt such that the stream of debt payments exactly offset the stream
of riskless after-tax cash flows being valued. The only non-zero cash flow to a
firm which constructs the arbitrage is the proceeds from issuing the offsetting
debt since the after-tax debt payments exactly offset the riskless after-tax cash
inflows. Therefore, the proceeds from issuing the offsetting debt equals the
market value of the riskless after-tax cash flows.
The arbitrage valuation approach is equivalent to the present value approach
when the riskless after-tax cash flows are discounted at after-corporate-tax
riskless interest rates. The riskless after-tax cash flows can also be valued using
the adjusted present value approach as the sum of the riskless after-tax cash
flows discounted at the before-tax interest rate plus the interest tax shields
from the incremental debt supported by the project discounted at the before-tax
interest rate. However, the arbitrage valuation approach shows that the ad-
justed present value approach provides the market value of riskless after-tax
cash flows only when the incremental debt used in the calculations equals the
market value of the remaining riskless after-tax cash flows in each period.

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