hard · Principles of Finance cost-of-capital-structure

What is the most defensible critique of this treatment for valuing the firm today?

1. The interest tax shield should be deferred: for the first 3 years the marginal tax benefit is effectively zero (so the after-tax cost approaches the 6% pre-tax rate), and only the present value of shields realized in year 4 onward should be capitalized at the 4.5% equivalent.
2. The analyst should instead gross up the cost of debt to roughly 8%, reasoning that tax-loss carryforwards make servicing the debt strictly more expensive to the firm than the stated 6% coupon during the entire multi-year tax-shelter period before profitability resumes.
3. The after-tax cost of debt is correct exactly as computed, because the statutory 25% corporate tax rate is the legally binding marginal rate applicable to the firm in every reporting period, regardless of the specific year-by-year timing of when taxable income is actually realized.
4. Because the firm currently holds a substantial deferred tax asset carried forward from several prior years of losses, the effective marginal tax rate on interest is permanently zero, so the full 6% pre-tax cost of debt should be applied across the entire valuation horizon.

Sign up free to see the explanation and track your rank →