Discounting methods and personal taxes

• DOI: http://doi.org/10.1111/eufm.12157
• Published date: 01 March 2019
• Date: 01 March 2019

D

310 © 2017 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2019;25:310–324.

DOI: 10.1111/eufm.12157

ORIGINAL ARTICLE

Discounting methods and personal taxes

Michael Dempsey

Professor of Fiannce, Faculty of Finance

and Banking, Ton Duc Thang University,

Ho Chi Minh City, Vietnam

Email: michaeljosephdempsey008

@gmail.com

Abstract

We advance models of valuation that incorporate personal

taxes. The models are general in allowing for uneven cash

flows, changes in debt levels, and changes in the costs of equity

and debt. The models are mutually consistent, are consistent

with the CAPM, and are consistent with the Modigliani and

Miller propositions allowing personal taxes.

KEYWORDS

valuation, taxes, tax system, CAPM, WACC

JEL CLASSIFICATION

G12, G31, G38

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INTRODUCTION

Even when we allow the simplification of no personal taxes, the issue of discounting in relation to

project debt continues to be controversial. For example, Fernandez (2004) proposes that the present

value of tax savings due to the tax-deductibility of interest payments on the firm’s debt is not their

discounted value. This is countered by Cooper & Nyborg (2006) who show that Fernandez’s result

is the outcome of combining equations that hold under the assumption that debt is fixed with

expressions that hold when debt leverage is fixed. Again, Inselbag & Kaauford (1997) demonstrate

that the adjusted present value (APV) method − which allows for a separate calculation of the value

to the firm of the tax-deductibility of interest payments on the debt − and the free cash flow (FCF)

method are consistent under either view of the riskiness of the tax deductibility of interest payments,

whereas Massari, Roncaglio, & Zanetti (2008) insist that the two methods are generally

inconsistent, and that the differences in outcome are non-trivial. In turn, Dempsey (2013) confirms

that the error in Massari et al. (2008) is similar to that in Fernadez (2004). Oded & Michel (2007)

offer a good number of examples of internal inconsistencies in textbooks with respect to the

recognition of debt in discounting methods.

The author wishes to thank an anonymous referee for highly valued input into the completion of the paper.

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