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Corporate valuation, standard recapitalization strategies and the value of tax savings in textbook valuation formulas

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Typically, in finance and valuation textbooks three different formulas, known as the weighted average cost of capital (WACC), the adjusted present value (APV) - and the flow to equity (FTE) - approach are proposed to calculate the present value of a levered firm. Recent results in research suggest that these formulas imply different types of recapitalization strategies, predetermining either absolute future debt levels or capital structures in future periods (D-strategy and L-strategy) leading to different tax shields and firm values if future firm values are uncertain. This paper will show that one of these two strategies attributed with riskless tax savings (the D-strategy) is not admissible in the expectations adaption regime necessary to apply risk adjusted CAPM-based rates of return on multiperiod uncertain cash flows. In contrast, the recapitalization strategy leading to riskier tax savings (L-strategy) is admissible. Standard valuation formulas that imply riskless tax savings thus overstate the tax benefits of debt financing. This result adds another possible explanation to the phenomenon that the effects of tax considerations upon capital structure decisions to be observed empirically are substantially smaller than suggested by standard corporate finance formulas.

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en

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application/pdf

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http://flora.insead.edu/fichiersti_wp/inseadwp2000/2000-46.pdf

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Copyright INSEAD. All rights reserved