hard · Principles of Finance valuation
An analyst values a stable firm with a single APV pass: unlevered value of operations plus the present value of the interest tax shield, discounting the shield at the cost of debt r_d. The firm maintains a CONSTANT market-value debt-to-value RATIO (rebalancing debt each period to a fixed fraction of value), not a fixed dollar debt level.
Holding everything else constant, what is the most precise consequence of discounting the tax shield at r_d rather than at the unlevered cost of equity r_U?
- It overstates firm value, because under ratio rebalancing the shield inherits the business risk of operations after the first period and should be discounted at r_U.
- It correctly states firm value, because interest is a contractual obligation and the tax shield always carries debt-like risk no matter which debt policy is chosen.
- It understates firm value, because ratio rebalancing actually makes the shield safer than the debt itself, so it should be discounted below the cost of debt, r_d, each period.
- It overstates firm value, because the shield should instead be discounted at the WACC, which always exceeds r_d whenever the firm carries any equity in its capital structure.
Sign up free to see the explanation and track your rank →
More Principles of Finance valuation practice
- What is its current market price?
- What is its Modified Duration?
- A 10-year corporate bond with a face value of $1,000 pays an annual coupon of 6%. If the c
- If the market yield to maturity (YTM) suddenly increases to 5.5%, what will happen to the
- If the stock price is 35 at expiration, what is the net profit?
- If the current market interest rate for similar bonds is 6%, how will the bond be priced i
- What is the current market price of the bond?
- A 5-year zero-coupon bond with a face value of 1,000 is curr… — What is the yield to matur