hard · Principles of Finance valuation

Holding all else equal, what is the directional effect of this discount-rate choice on the estimated tax-shield value, and why?

1. It is correct exactly as stated, because tax shields are contractual cash flows tied directly to the underlying debt repayment schedule and therefore always carry debt-like risk regardless of the firm's chosen leverage policy going forward.
2. 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
3. It actually understates the true tax-shield value, because discounting purely at the cost of debt ignores the personal-tax disadvantage attached to debt income, which would otherwise lower the required return demanded on the shields themselves.
4. It has essentially no net effect on total APV whatsoever, because the chosen tax-shield discount rate merely reallocates value between the unlevered component and the shield component without ever changing their combined total sum.

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