The value of the firm diminishes as its overall risk increases, because the expected value of the
interest tax shield declines and the expected bankruptcy costs rises.
The fundamental scenario that previous studies used is this: A long-term mortgage borrower can save the
interest tax shield as well as the difference in payments, but a short-term mortgage borrower can start saving after paying off the loan.
268 305 equals the NPV of ATNCF, U plus Debt
Interest Tax Shield 7 ATNCF, L 50 NPV @ [k.
In my paper on riskless cash flows, I showed that the
interest tax shields associated with riskless cash flows can either be equivalently treated as increasing cash flows by the
interest tax shield, or as decreasing the discount rate to the after-tax riskless rate.
As long as the mutual company's loans are treated as debt for tax purposes, this
interest tax shield can be worth as much as 20 to 30 percent of total borrowing to the new company.
However, the overall effect on the WACC depends upon the relative importance of the positive effects of deleveraging, as noted above, versus the effect of losing the corporate
interest tax shield.
4 They also show that long-term debt increases the debt capacity of the firm, allowing for a larger
interest tax shield on debt.
The tax incentive is the additional
interest tax shield.
The current debt level, which is based on current firm value, is known, so in the absence of default risk the
interest tax shield at the end of the first period is also certain.
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.
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.
