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.
is the period t
interest tax shield. In the free cash flow (FCF) valuation framework this adjustment is a flexible and consistent method to include the value of the tax deductibility of interest into the overall value of levered firm.
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.
As could be seen from the findings and example of Inselbag and Kaufold (1997), and as a general expression for Ke and WACC derived by Tham and Velez-Pareja (2002), both the cost of levered equity and the Weighted Average Cost of Capital depend on the value of the
interest tax shield (VTS), and in the case of finite cash flows valuation, they could be changing from period to period if certain choice is made for the rate to discount expected tax shields.
If the expectations theory of interest rates holds, firms pay the same present value of interest in the long run regardless of debt maturity; however, issuing long-term debt accelerates interest payments, thus maximizing the present value of the
interest tax shield. Brick and Ravid (1985) use this logic to argue that debt maturity should increase with the slope in the yield curve.
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.
We measure the maximum potential tax benefits associated with a leverage increase in LRs and LBOs by a firm's
interest tax shield (interest expenses multiplied by the firm's effective tax rate) as a percentage of the firm's total assets in the announcement year (ITS/TA).
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. If the positive effects mentioned above more than offset the loss of the
interest tax shield, firms could more easily finance expansion as a result of the Armey tax reform program.
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.
PV(
Interest tax shield) = [summation of] [([T%.sup.*]I[E.sub.t])] where t = 1 to 5 [2]
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.
