Risky Tax Shields and Risky Debt: An Exploratory Study
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Dec 1, 2010
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Abstract
This article identifies three sources of risk for tax shields (TS): two of them are associated with debt risk and one is associated with operating risk. A set of conditions for defining risky debt associated with cash flow, not with earnings, is presented. It further shows that realization of tax shields for finite cash flows in a period of time t is correlated with Earnings before Interest and Taxes (EBIT) plus Other Income (EBITO), not with interest expenses at time t. The author questions the validity of Miles and Ezzell’s proposal. With the results of a Montecarlo Simulation (MCS) the behavior of tax shields, Cash Flow to Debt (CFD) and (EBITO) are examined. In conclusion, the article suggests that it is not reasonable to define the risk of TS as measured by a single discount rate, but rather as a mix of debt risk and operating risk.
Keywords
firm valuation, tax shields, cash flows, Montecarlo Simulation, discount rate for tax shields, risky debt, risky tax shields, weighted average cost of capitalvaloración de la empresa, amparos fiscales, flujos de caja, simulación de Montecarlo, tasa de descuento para amparos fiscales, costo promedio ponderado del capitalcusto médio ponderado do capital, valorização da empresa, incentivos fiscais, fluxo de caixa, simulação de Monte Carlo, taxa de desconto para incentivos fiscais, riscos de alavancagem, riscos dos incentivos fiscais
References
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Bank for International Settlements, Basel Committee on Banking Supervision (2006). International Convergence of Capital Measurement and Capital Standards A Revised Framework. Retrieved on November 29, 2010, from www.bis.org/publ/bcbs128.pdf
Brealey, R.A. and Myers, S.C. (2003). Principles of Corporate Finance (7th ed.). New York: Mc-Graw-Hill.
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Dammon, R.M. and Senbet, L.W. (1988). The Effect of Taxes and Depreciation on Corporate Investment and Financial Leverage. The Journal of Finance, 43 (2), 357-373.
Damodaran, A. (2002). Investment Valuation (2nd Ed.). Hoboken, N.J.: John Wiley & Sons. Retrieved from: http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch15.pdf
Valuation Approaches and Metrics: A Survey of the Theory and Evidence. (2005). Foundations and Trends in Finance, 1 (8), 693-784. Retrieved from: http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/valuesurvey.pdf
Díaz, G. and Vélez-Pareja, I. (2010). Estimating the Appropriate Risk Profile for the Tax Savings: A Contingent Claim Approach. Working paper. Retrieved from: http://ssrn.com/abstract=1667621
El Tiempo (2004, August 10). Ley 55: solo 10 empresas salvadas. Retrieved on Nov 2, 2010, from: http://www.eltiempo.com/archivo/documento/MAM-1591980
Fama, E.F. and French, K.R. (1998). Taxes, Financing Decisions, and Firm Value. The Journal of Finance, 53 (3), 819-843.
Grabowski, R.J. (2009). Problems with Cost of Capital Estimation in the Current Environment. Journal of Applied Research in Accounting and Finance (JARAF), 4 (1), 31-40.
Graham, J.R. (2000). How big are the tax benefits of debt? The Journal of Finance, 55 (5), 1901-1941.
Harris, R.S. and Pringle, J.J. (1985). Risk-Adjusted Discount Rates-Extensions from the Average-Risk Case. Journal of Financial Research (8), 237-244.
Kaplan, S.N. and Ruback, R.S. (1995). The Valuation of Cash Flow Forecasts: An Empirical Analysis. The Journal of Finance, 50 (4), 1059-1093.
Kemsley, D. and Nissim, D. (2002). Valuation of the Debt Tax Shield. The Journal of Finance, 57 (5), 2045-2073.
Kolari, J.W. and Vélez-Pareja, I. (2010). Corporation Income Taxes and the Cost of Capital: A Revision. Working paper. Retrieved from: http://papers.ssrn.com/abstract=1715044
Lewellen, W.G. and Emery, D.R. (1986). Corporate Debt Management and the Value of the Firm. The Journal of Financial and Quantitative Analysis, 21 (4), 415-426.
Luehrman, T. (1997). Using APV: A Better Tool for Valuating Operations. Harvard Business Review, May-June, 145-154.
Miles, J.A. and Ezzell, J.R. (1985). Reformulating Tax Shield Valuation: A Note. The Journal of Finance, 40 (5), 1485-1492.
Modigliani, F. and Miller, M.H. (1958). The Cost of Capital, Corporation Taxes and the Theory of Investment. The American Economic Review. XLVIII, 261-297.
Corporate Income Taxes and the Cost of Capital: A Correction. (1963). American Economic Review, 53 (3), 443-453.
Myers, S.C. (1974). Interactions of Corporate Financing and Investment Decisions-Implications for Capital Budgeting. The Journal of Finance, 29 (1), 1-25.
Newbould, G.D.; Chatfield, R.E. and Anderson, R.F. (1992). Leveraged Buyouts and Tax Incentives. Financial Management, 21 (1), 50-57.
Ruback, R.S. (2002). Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows. Financial Management, 31 (2), 85-103.
Superintendencia de Sociedades (2010). Sirem. Retrieved on June 11, 2010, from: http://sirem.supersociedades.gov.co/SIREM/index.jsp
Taggart, R.A. Jr. (1991). Consistent Valuation and Cost of Capital: Expressions with Corporate and Personal Taxes. Financial Management (Autumn), 8-20.
Talmor, E.; Haugen, R. and Barnea, A. (1985). The Value of the Tax Subsidy on Risky Debt. The Journal of Business, 58 (2), 191-202.
Tham, J. and Vélez-Pareja, I. (2001). The Correct Discount Rate for the Tax Shield: The N-period Case (April). Retrieved from: http://ssrn.com/abstract=267962 or doi:10.2139/ssrn.267962.
Principles of Cash Flow Valuation: An Integrated Market-based Approach. (2004). Boston: Academic Press.
Cost of Capital with Levered Cost of Equity as the Risk of Tax Shields. (2010, August 9). Working paper. Retrieved from: http://ssrn.com/ abstract=1655244
U.S. Courts (2010). Table F-2: U.S. Bankruptcy Courts. Retrieved on August 7, 2010, from: http://www.rib.uscourts.gov/Docs/Stats/table_f2.pdf
U.S. Small Business Administration (2010). Statistics of U.S. Businesses, Business Dynamics Statistics, Business Employment Dynamics, and Nonemployer Statistics. Retrieved on Nov. 2, 2010, from: http://www.sba.gov/advo/research/data.html
U.S. Small Business Administration, Office of Advocacy (2010). Private Firms, Establishments, Employment, Annual Payroll and Receipts by Firm Size, 1988-2007 (table).Retrieved on August 7, 2010, from: http://www.sba.gov/advo/research/us88_07.pdf
Vélez-Pareja, I. (2009, July). Return to Basics: Are You Properly Calculating Tax Shields? Retrieved from: http://ssrn.com/abstract=1306043
Calculating Tax Shields from Financial expense with Losses Carried Forward. (2010, May). Retrieved from: http://ssrn.com/abstract=1604082
Viana Rojas, J. (2009, May 11). Más empresas buscaron su salvación en el primer trimestre; crisis empezó a pasar cuenta de cobro. Portafolio. Retrieved on Nov 2, 2010, from: http://www.portafolio.com.co/economia/economiahoy/2009-05-11/ARTICULO-WEB-NOTA_INTERIOR_PORTA-5171194.html
World Bank (2010). Total businesses registered (number). Retrieved on Nov. 2, 2010, from: http://data.worldbank.org/indicator/IC.BUS.TOTL
Wrightsman, D. (1978). Tax Shield Valuation and the Capital Structure Decision. The Journal of Finance, 33 (2), 650-656.
Bank for International Settlements, Basel Committee on Banking Supervision (2006). International Convergence of Capital Measurement and Capital Standards A Revised Framework. Retrieved on November 29, 2010, from www.bis.org/publ/bcbs128.pdf
Brealey, R.A. and Myers, S.C. (2003). Principles of Corporate Finance (7th ed.). New York: Mc-Graw-Hill.
Cordes, J.J. and Sheffrin, S.M. (1983). Estimating the Tax Advantage of Corporate Debt. The Journal of Finance, 38 (1), 95-105.
Dammon, R.M. and Senbet, L.W. (1988). The Effect of Taxes and Depreciation on Corporate Investment and Financial Leverage. The Journal of Finance, 43 (2), 357-373.
Damodaran, A. (2002). Investment Valuation (2nd Ed.). Hoboken, N.J.: John Wiley & Sons. Retrieved from: http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch15.pdf
Valuation Approaches and Metrics: A Survey of the Theory and Evidence. (2005). Foundations and Trends in Finance, 1 (8), 693-784. Retrieved from: http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/valuesurvey.pdf
Díaz, G. and Vélez-Pareja, I. (2010). Estimating the Appropriate Risk Profile for the Tax Savings: A Contingent Claim Approach. Working paper. Retrieved from: http://ssrn.com/abstract=1667621
El Tiempo (2004, August 10). Ley 55: solo 10 empresas salvadas. Retrieved on Nov 2, 2010, from: http://www.eltiempo.com/archivo/documento/MAM-1591980
Fama, E.F. and French, K.R. (1998). Taxes, Financing Decisions, and Firm Value. The Journal of Finance, 53 (3), 819-843.
Grabowski, R.J. (2009). Problems with Cost of Capital Estimation in the Current Environment. Journal of Applied Research in Accounting and Finance (JARAF), 4 (1), 31-40.
Graham, J.R. (2000). How big are the tax benefits of debt? The Journal of Finance, 55 (5), 1901-1941.
Harris, R.S. and Pringle, J.J. (1985). Risk-Adjusted Discount Rates-Extensions from the Average-Risk Case. Journal of Financial Research (8), 237-244.
Kaplan, S.N. and Ruback, R.S. (1995). The Valuation of Cash Flow Forecasts: An Empirical Analysis. The Journal of Finance, 50 (4), 1059-1093.
Kemsley, D. and Nissim, D. (2002). Valuation of the Debt Tax Shield. The Journal of Finance, 57 (5), 2045-2073.
Kolari, J.W. and Vélez-Pareja, I. (2010). Corporation Income Taxes and the Cost of Capital: A Revision. Working paper. Retrieved from: http://papers.ssrn.com/abstract=1715044
Lewellen, W.G. and Emery, D.R. (1986). Corporate Debt Management and the Value of the Firm. The Journal of Financial and Quantitative Analysis, 21 (4), 415-426.
Luehrman, T. (1997). Using APV: A Better Tool for Valuating Operations. Harvard Business Review, May-June, 145-154.
Miles, J.A. and Ezzell, J.R. (1985). Reformulating Tax Shield Valuation: A Note. The Journal of Finance, 40 (5), 1485-1492.
Modigliani, F. and Miller, M.H. (1958). The Cost of Capital, Corporation Taxes and the Theory of Investment. The American Economic Review. XLVIII, 261-297.
Corporate Income Taxes and the Cost of Capital: A Correction. (1963). American Economic Review, 53 (3), 443-453.
Myers, S.C. (1974). Interactions of Corporate Financing and Investment Decisions-Implications for Capital Budgeting. The Journal of Finance, 29 (1), 1-25.
Newbould, G.D.; Chatfield, R.E. and Anderson, R.F. (1992). Leveraged Buyouts and Tax Incentives. Financial Management, 21 (1), 50-57.
Ruback, R.S. (2002). Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows. Financial Management, 31 (2), 85-103.
Superintendencia de Sociedades (2010). Sirem. Retrieved on June 11, 2010, from: http://sirem.supersociedades.gov.co/SIREM/index.jsp
Taggart, R.A. Jr. (1991). Consistent Valuation and Cost of Capital: Expressions with Corporate and Personal Taxes. Financial Management (Autumn), 8-20.
Talmor, E.; Haugen, R. and Barnea, A. (1985). The Value of the Tax Subsidy on Risky Debt. The Journal of Business, 58 (2), 191-202.
Tham, J. and Vélez-Pareja, I. (2001). The Correct Discount Rate for the Tax Shield: The N-period Case (April). Retrieved from: http://ssrn.com/abstract=267962 or doi:10.2139/ssrn.267962.
Principles of Cash Flow Valuation: An Integrated Market-based Approach. (2004). Boston: Academic Press.
Cost of Capital with Levered Cost of Equity as the Risk of Tax Shields. (2010, August 9). Working paper. Retrieved from: http://ssrn.com/ abstract=1655244
U.S. Courts (2010). Table F-2: U.S. Bankruptcy Courts. Retrieved on August 7, 2010, from: http://www.rib.uscourts.gov/Docs/Stats/table_f2.pdf
U.S. Small Business Administration (2010). Statistics of U.S. Businesses, Business Dynamics Statistics, Business Employment Dynamics, and Nonemployer Statistics. Retrieved on Nov. 2, 2010, from: http://www.sba.gov/advo/research/data.html
U.S. Small Business Administration, Office of Advocacy (2010). Private Firms, Establishments, Employment, Annual Payroll and Receipts by Firm Size, 1988-2007 (table).Retrieved on August 7, 2010, from: http://www.sba.gov/advo/research/us88_07.pdf
Vélez-Pareja, I. (2009, July). Return to Basics: Are You Properly Calculating Tax Shields? Retrieved from: http://ssrn.com/abstract=1306043
Calculating Tax Shields from Financial expense with Losses Carried Forward. (2010, May). Retrieved from: http://ssrn.com/abstract=1604082
Viana Rojas, J. (2009, May 11). Más empresas buscaron su salvación en el primer trimestre; crisis empezó a pasar cuenta de cobro. Portafolio. Retrieved on Nov 2, 2010, from: http://www.portafolio.com.co/economia/economiahoy/2009-05-11/ARTICULO-WEB-NOTA_INTERIOR_PORTA-5171194.html
World Bank (2010). Total businesses registered (number). Retrieved on Nov. 2, 2010, from: http://data.worldbank.org/indicator/IC.BUS.TOTL
Wrightsman, D. (1978). Tax Shield Valuation and the Capital Structure Decision. The Journal of Finance, 33 (2), 650-656.
How to Cite
Vélez Pareja, I. (2010). Risky Tax Shields and Risky Debt: An Exploratory Study. Cuadernos De Administración, 23(41). https://doi.org/10.11144/Javeriana.cao23-41.efrd
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