DISCUSS WITH EDWARD BODMER : TAX SHIELD AND WACC

Karnen
It might be of interest to you in understanding the crucial role of TS (Tax Shield) discount rate in deriving a correct cost of capital formula….

Edward Bodmer

Hello Karnen:

I have become obsessed with you questions and ideas.  I think that the WACC issues can be derived by simple models and clear thinking concepts rather than dense formulas.  I am making simple models to demonstrate various ideas and also videos.  I will be very interested in your thoughts on this.

I have attached a couple of files and articles on tax shields and cost of capital etc.

The first file demonstrates that when the target capital structure does not equal the current capital structure, discounting free cash flows at the WACC (which does not change in theory when the capital structure changes) gives the same answer as computing a new cost of equity with changing capital structure.

The second file is the beginning of work on the tax effects of interest.

The other attachments are articles on WACC and taxes etc that I am reviewing for our analysis.

Karnen

The (required) return to levered equity will depend as well on the assumption we put on the discount rate for Tax Shield. Some use cost of debt, or return to unlevered equity or between. You could google a whole bunch of finance papers discussing this issue.

WACC is a general formula, the most important what we are going to put into the return to levered equity (Ke). Knowing that TS discount rate assumption is also part of Ke then different assumption for TS discount rate will impact the Ke.

Edward Bodmer

I have been working very hard on your issue and I am attaching the set of videos I have made on this.

 Interest Shield Exercise https://www.youtube.com/watch?v=G6BBvAFHJGo Interest Shield Exercise https://www.youtube.com/watch?v=9LKppeYudVU Un-lever and Re-lever with Tax Shield https://www.youtube.com/watch?v=jaLOx3RJFkc Theory of Debt Beta and WACC https://www.youtube.com/watch?v=n_csEtMHveA Mechanics of Debt Beta and WACC https://www.youtube.com/watch?v=Bvp0ruVYBSw Unlever and Re-lever with Varying WACC https://www.youtube.com/watch?v=7ny67y-EpR8 Growth Rate, Tax Shields and WACC https://www.youtube.com/watch?v=oKNmQ9fimZc Circularity, WACC and Ku https://www.youtube.com/watch?v=2EPd8_yi_0M Growth and WACC Bias Target Capital Structure without Taxes Target Capital Structure with Tax Shield

January 2017

Posted in ARTICLES & VIDEOS, COST OF CAPITAL.