Consistent Cash Flow Valuation with Tax‐Deductible Debt: a Clarification

DOIhttp://doi.org/10.1111/j.1468-036X.2011.00625.x
Date01 September 2013
AuthorMike Dempsey
Published date01 September 2013
European Financial Management, Vol. 19, No. 4, 2013, 830–836
doi: 10.1111/j.1468-036X.2011.00625.x
© 2011 John Wiley & Sons Ltd
Consistent Cash Flow Valuation with
Tax-Deductible Debt: a Clarification
Mike Dempsey
Department of Accounting and Finance, Monash University,PO Box 197, Caulfield East, Vic 3145,
Australia
E-mail: michael.dempsey@monash.edu.au
Abstract
Massari et al. (2008) argue that the weighted average cost of capital (WACC)
approach to discounting expected cash flows is generally inconsistent with the
adjusted present value (APV) approach. We show that their argument results from,
first, taking a WACC expression that assumes a fixed level of debt in perpetuity and
applying it to a scenario where the debt level varies stochastically; and, second,
discounting the tax savings from stochastic debt at the rate appropriate for fixed
debt. Our paper draws attention to the fundamental proposition by which such
errors are avoided whencross-referencing valuation methods. The outcome is that
the APV and WACC methods are shown to be algebraically consistent with each
other.
Keywords: valuation techniques,growth,APV ,wacc,tax-shields
JEL classification: G31, G32
1. Introduction
Massari et al. (2008) argue that compatibility between the adjusted present value
(APV) and the weighted average cost of capital (WACC) approaches to discounting
expected cash flows in a steady-growth scenario requires ‘some unusual assumptions’
(pp. 153, 154) in relation to the discount rate used in calculating the tax savings due
to debt. This paper shows how their conclusion is the outcome of taking discount
rates that relate to a scenario of fixed debt in perpetuity and applying them to
stochastically variable debt. Their misapplied rates are the firm’s weighted average
cost of capital (WACC) and the discount rate for the f irm’s tax savings due to debt.
As a correction, we present a guiding principle that ensures that such errors are
avoided when moving between assumptions on the risk of the debt tax savings. The
outcome is that the APV and WACC methods can be demonstrated to be algebraically
equivalent.
The author wishes to express sincere thanks to the anonymous reviewer of the paper for
making considerable suggestions as to the improvement of the paper.

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