Corporate Taxes and

Valuation
Knut P. Heen PhD
Associate Professor
Molde University College
Road Map
Based on HGT chapter 13
Corporate Taxes
The Adjusted Present Value (APV) Method
The Weighted Average Cost of Capital (WACC) Method
Discounting Cash Flows to Equity

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Corporate Taxes
Corporate taxes are calculated after interest
payments are deducted
Interest payments are tax deductible
Dividend payments are not tax deductible
Sales
Cost of goods sold
EBITDA
Depreciation
EBIT
Interest
EBT
Taxes
Earnings

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Tax Adjustments in FCFs
Free cash flows
EBIT
+ Depreciation
– Investments (PPE & WC)
– Taxes (as if the firm is 100-percent equity financed)

No adjustment for interest tax shield in FCFs

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Two Methods to Account for Debt
Financing
The APV-method

The WACC-method
Adjust discount rate for tax shield

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The Unlevered Cost of Capital
Balance sheet
Assets Liabilities & Equity
Unlevered Assets, UA Debt, D
Debt Tax Shield, TX Equity, E

Asset beta & asset return

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The Hamada-Model (1)
Hamada (1972) assumes perpetual default-free debt
Interest payment each year

Tax shield each year

Present value of tax shields

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The Hamada-Model (2)
Asset beta

Equity beta

Identifying the Unlevered Cost of Capital

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APV & the Discount Rate for TX
APV

If debt schedule is certain (no default, no change in pay-back)

Otherwise, the tax shields are risky (future debt level may depend on the
state of the economy → future tax shields )

APV is also compatible with real options

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APV Example 13.2
Project cash flows in millions

Financing plan
All-equity until start of year 3
Borrow 2 billion at start of year 3 and retire equity of 2 billion

Cost of capital and tax rate

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APV Example 13.2 cont’d
PV of unlevered cash flows

PV of debt tax shields

PV of levered project

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WACC
Tax adjusted cost of capital

Problem

Solution → Assume constant “target” D/E-ratio

But constant D/E-ratio → Future is a function of UA
The tax shields are therefore risky,

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The Cost of Risky Debt
Risky debt
p = 0.96
No Default Receive promised yield 114

100

Default Receive recovery rate 60

p = 0.04

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Shareholder Value vs. Firm Value
Absence of default
Maximizing shareholder value = maximizing firm value
Shareholders are residual claimants; debt is always paid (not a function of
firm value)

Presence of default
Maximizing shareholder value ≠ maximizing firm value
Creditors are residual claimants in some states,
Positive NPV projects from the firm’s perspective may therefore be negative
NPV projects from the shareholders’ perspective

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Example
Assets in place
The firm owns a project which pays out 200 in the good state and
nothing in the bad state
Both states are equally likely, 50/50
The project lasts for one period (we normalize rf to zero)
The firm also own cash of 10

Financing in place
The firm has debt outstanding which matures after one period
The firm has promised to pay debt holders 100

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Example cont’d
New project
The project requires an investment of 10 today
The project pays out 50 in the bad state and nothing in the good state

Should the shareholders accept the project?

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Example cont’d
Cash flows without project
Good
Bad
Expected

Cash flows with project

Good
Bad
Expected
Change

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Risky Debt & Shareholder Value
Absence of default

All projects which increase A also increase E

Presence of default

Projects which increase A when A – D < 0 does not increase shareholder

value
Projects which increase A when A – D > 0 does increase shareholder
value

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Cash Flows to Equity
In the case of risky debt
Shareholders may want to calculate equity-NPV rather than firm-NPV
Calculate cash flows to equity
Which discount rate should we use?
Discounting is problematic
Equity is really an option (rE is path-dependent unlike rUA/WACC)
Better to use the real option approach to value the equity

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