The expected value of the interest tax shields declines, because greater risk decreases the probability that a firm will be able to exploit those shields in any given period.
Thus interest tax shields are more beneficial to firms with relatively high and stable taxable income compared to firms with large accumulated tax loss from previous years and uncertain future prospects.
However this assumption might not hold, and applying standard ReOI expression (1) or (8) can lead to aberrations in financial performance measurement due to divergence in actual and implicit interest tax shields.
The drawback of the VAIC formulation (12) is the need to explicitly estimate the interest tax shields TS, which may not be straightforward since the actual tax shield realizations depend not only on the interest expenses and corporate tax rate, but are a function of EBIT and other sources of tax deductibility available to the firm.
This unreasonable result occurs even with no bankruptcy risk when discounting interest tax shields using both risky debt rates and unlevered equity rates in their tax models.
That is, many highly profitable and big firms with investment grade credit ratings use conservative levels of debt even though the trade-off theory predicts that such firms should use higher levels of interest tax shields (e.
Other factors possibly altering the usability of depreciation tax shields are the alternative minimum tax and the amount of other corporate tax shields, such as interest tax shields
Because the interest tax shields are included in the cash flows, the CCF approach is easier to apply whenever debt is forecasted in levels instead of as a percent of total enterprise value.
In that method, interest tax shields are excluded from the FCFs and the tax deductibility of interest is treated as a decrease in the cost of capital using the after-tax weighted average cost of capital (WACC).
where the second terms in Equations (8) and (9) are the net interest tax shields
on long-term debt.
Under this tax structure, there is an increase in the depreciation and interest tax shields
, but it assumes the acquisition can be structured in such a way as to avoid the capital gains tax levied on the target firm.
These relationships can take on three different forms, as shown in the three panels of Exhibit 2, depending on what is assumed about the time pattern and risk of the firm's interest tax shields