Understanding the Present Value of Tax Shields
The present value of tax shields (PVTS) is a crucial component of valuation models, particularly in the context of leveraged firms. It represents the present value of future tax savings generated by the company’s interest expense. This tax advantage arises because interest payments are tax-deductible, effectively reducing the company’s tax liability. The PVTS is calculated by discounting the expected future tax savings at an appropriate discount rate.
The choice of discount rate for the PVTS is a critical decision that can significantly impact the valuation outcome. Two common approaches are:
- Using the required return to unlevered equity (Ku): This approach assumes that the tax savings are generated by the company’s overall operations and are therefore discounted at the cost of unlevered equity, which reflects the risk of the company’s business without considering the impact of debt.
- Using the required return to debt (Kd): This approach assumes that the tax savings are directly related to the company’s debt financing and are therefore discounted at the cost of debt, which reflects the risk of the company’s debt obligations.
The Impact of Discount Rate Choice on Valuation
The choice of discount rate for the PVTS can have a significant impact on the valuation outcome. Using Kd as the discount rate generally results in a higher PVTS compared to using Ku. This is because Kd is typically lower than Ku, leading to a higher present value of the tax savings.
For example, consider a company with a cost of unlevered equity (Ku) of 10% and a cost of debt (Kd) of 5%. If the company expects to generate $1 million in tax savings annually for the next 10 years, the PVTS using Ku would be approximately $6.14 million, while the PVTS using Kd would be approximately $7.72 million. This difference of $1.58 million highlights the significant impact of the discount rate choice on the valuation.
Which Approach is Better?
The choice between using Ku or Kd for the PVTS depends on the specific circumstances of the company and the valuation model being used. There is no universally accepted “better” approach, and the decision should be based on a careful analysis of the following factors:
- The nature of the company’s operations: If the company’s operations are highly cyclical or volatile, using Ku may be more appropriate as it reflects the overall risk of the business. However, if the company’s operations are relatively stable, using Kd may be more appropriate as it focuses on the risk of the debt financing.
- The company’s capital structure: If the company has a high level of debt, using Kd may be more appropriate as the tax savings are more directly related to the debt financing. However, if the company has a low level of debt, using Ku may be more appropriate as the tax savings are more closely tied to the overall operations of the business.
- The valuation model being used: Some valuation models, such as the adjusted present value (APV) model, explicitly incorporate the PVTS using Kd. Other models, such as the discounted cash flow (DCF) model, may not explicitly incorporate the PVTS, but it can be included as a separate adjustment.
Case Study: Tesla
Tesla, a leading electric vehicle manufacturer, provides an interesting case study. The company has a high level of debt and a volatile business model. In this case, using Ku for the PVTS may be more appropriate as it reflects the overall risk of the business. However, Tesla’s tax savings are also significantly influenced by its debt financing, so using Kd may also be considered. Ultimately, the best approach would depend on the specific valuation model being used and the assumptions made about Tesla’s future cash flows and risk profile.
Conclusion
The choice of discount rate for the PVTS is a critical decision that can significantly impact the valuation outcome. Using Kd generally results in a higher PVTS compared to using Ku, but the best approach depends on the specific circumstances of the company and the valuation model being used. A careful analysis of the company’s operations, capital structure, and the valuation model being used is essential to determine the most appropriate discount rate for the PVTS.