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Unformatted text preview: always give the same value. This result is logical, since all the methods analyze
the same reality under the same hypotheses; they differ only in the cash flows taken as the
starting point for the valuation. The tax shield of a given year is D Kd T. D is the value of debt,
Kd is the required return on debt, and T is the corporate tax rate. D Kd are the interest paid in a
given year. The formulas used in the paper are valid if the interest rate on the debt matches the
required return on debt (Kd), or to put it another way, if the debt’s market value is identical to
its book value. The formulas for when this is not the case, are given in Appendix 3. * I would like to thank my colleagues José Manuel Campa and Charles Porter for their wonderful help revising earlier
manuscripts of this paper, and an anonymous referee for very helpful comments. I would also like to thank Rafael
Termes and my colleagues at IESE for their sharp questions that encouraged me to explore valuation problems.
IESE Business School-University of Navarra In Section 2, the ten methods and nine theories are applied to an example. The nine theories
1) Fernández (2004). Assumes that there are no leverage costs and that the risk of
increases in debt is equal to the risk of the free cash flow.
2) Damodaran (1994). To introduce leverage costs, Damodaran assumes that the
relationship between the levered and unlevered beta is: ßL = ßu + D (1-T) ßu / E (instead
of the relationship obtained in Fernández (2004), ßL = ßu + D (1-T) (ßu - ßd) / E).
3) Practitioners’ method. To introduce higher leverage costs, this method assumes that the
relationship between the levered and unlevered beta is: ßL = ßu + D ßu / E.
4) Harris and Pringle (1985) and Ruback (1995). These theories assume that the leveragedriven value creation or value of tax shields (VTS) is the present value of the tax shields
(D Kd T) discounted at the required return on the unlevered equity (Ku). According to
them, VTS = PV[D Kd T ; Ku].
5) Myers (1974), who assumes that the value of tax shields (VTS) is the present value of
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This note was uploaded on 05/10/2013 for the course MBA MBA taught by Professor Mba during the Fall '11 term at ESLSCA.
- Fall '11