Discontinuous financing based on market values and the value of tax shields

Abstract

The tax shield as present value of debt-related tax savings plays an important role in firm valuation. Driving the risk of future debt levels, the firm's strategy to adjust the absolute debt level to future changes of the firm value, labeled as (re-) financing policy, affects the value of tax shields. Standard discounted cash flow (DCF) models offer two simplified (re-) financing policies originally introduced by Modigliani and Miller (MM) as well as Miles and Ezzell (ME). In this paper, we introduce a discontinuous financing policy that refers to the refinancing intervals, i.e., the maturity structure of the firm's debt. By deriving APV valuation and beta unlevering equations that allow for this discontinuous financing policy, we show the MM and ME policies to be special cases of the proposed extension. While we document the effect of discontinuous refinancing to be economically significant when leverage is high and refinancing periods are extremely long, our results suggest that for low-levered firms with short refinancing periods, the traditional continuous refinancing-based models (like the Miles/Ezzell model) produce relatively robust value estimates. Combining capital structure and maturity structure choices, our model extends the set of feasible financing policies in DCF valuation models.

Valuation with mixed financing strategies

“…In this second phase, all variables associated with the valuation increase at a uniform and constant growth rate g. In addition, we suppose that the business risk does not change over time, which results in a constant cost of equity of the unlevered firm q u . Since it is not the focus of our analysis, the costs of financial distress and the possibility of default are not considered such that the cost of debt corresponds to the risk-free interest rate r. This strong assumption can easily be relaxed by considering the cost of debt instead of the risk-free interest rate as it is done in Clubb and Doran (1995) and Arnold et al (2018). 1 Moreover, it is assumed that interest on debt is fully deductible from taxable income.…”

“…The interaction between passive debt management in the explicit forecast phase and active debt management in the steady-state phase has already been examined as hybrid financing (Kruschwitz et al 2007;Dierkes and Gröger 2010). Furthermore, discontinuous financing as another mix of active and passive debt management was developed (Clubb and Doran 1995;Arnold et al 2018Arnold et al , 2019, but it has been of little relevance for corporate valuation practice so far and it is unclear how to apply this financing strategy in a two-phase model.…”

“…Arnold et al (2019) enhanced the valuation formula to a perpetuity with a constant growth rate. Since we pick up on the research of Arnold et al (2018) we use the term discontinuous financing instead of lagged debt management.…”

“…Although discontinuous financing is a recognized concept in the literature of corporate valuation, it is so far of little relevance for corporate valuation practice. In this study, we present a simplified derivation of the valuation equation for the approach that Arnold et al (2018) pursued. This simplified derivation is more intuitive and enhances the understanding of discontinuous financing.…”

“…With the help of the simulation analysis, we can not only determine the distributions of the deviations of the market values but also estimate the influence of different input parameters. Thereby, we expand the example of Arnold et al (2018) who compare firm values under discontinuous financing for various lengths of planning phases and three different debt-to-market value ratios. We conclude that the use of mixed financing strategies constitutes a reasonable and promising alternative to pure financing strategies in depicting the financing behavior of a firm.…”