hard · Principles of Finance valuation
A target generates stable pre-tax operating cash flow and is being valued via APV. An analyst computes the unlevered value, then adds the present value of interest tax shields by discounting the tax shields at the cost of DEBT, assuming the firm maintains a CONSTANT market-value debt-to-value RATIO going forward.
Holding all else equal, what is the directional effect of this discount-rate choice on the estimated tax-shield value, and why?
- It is correct as stated, because tax shields are contractual cash flows tied to debt and therefore always carry debt-like risk regardless of the firm's leverage policy
- It overstates the tax-shield value, because under a constant debt RATIO future debt levels scale with firm value and are uncertain, so the shields share the operating assets' risk and should be discounted at the higher unlevered cost of capital
- It understates the tax-shield value, because discounting at the cost of debt ignores the personal-tax disadvantage of debt that would otherwise lower the required return on the shields
- It has no effect on total APV, because the choice of tax-shield discount rate only reallocates value between the unlevered and shield components without changing their sum
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