Debt beta is the result of the ratio of credit spread and market risk premium. If it is taken into account, the company value usually increases.
What is the cash flow effect of the tax shield?
In connection with the determination of the beta factor, there is always the question “How safe is it to use the tax advantage of external financing? ”. For the valuer, it is important to differentiate between the cash flow effect and the risk effect. In combination, these two effects define the amount of the often not inconsiderable value of the tax shield. A good understanding of the basics of the Tax Shield is therefore absolutely relevant for company valuation. (Read more about the basics in the article The Tax Shield in company valuation.)
What is the cash flow effect of the tax shield?
The tax shield is understood to mean the tax advantage of debt financing due to the deductibility of interest from the tax base. In Germany, this generally applies in full to corporation tax and 75% to business tax. In many countries, there is even full tax deductibility of interest on borrowed capital as part of taxation at company level.
This effect can be described as the cash flow effect of the tax shield. As part of the income value process, direct consideration is taken into account in the income calculation. When using the DCF procedure, this is usually included in the cost of capital rate, the so-called WACC, by reducing borrowing costs by the amount of the exempted tax rate.
What is the risk effect of the Tax Shield?
In order to understand the risk effect of the tax shield, it helps to first look again at the effect of the leverage effect. Debt capital therefore increases risks for equity investors because the interest burden does not or does not vary completely with the success of the company. If — as usual — the cost of equity is higher than the cost of borrowing, the return and risk for equity providers will increase as the debt ratio rises, not only in absolute terms, but also relatively. The return on equity increases with higher indebtedness and vice versa.
As described above, in addition to the disadvantage of increasing risk for equity investors, additional borrowed capital now has the advantage of an additional tax shield. As a result, the leverage effect of interest rates does not in fact increase risks in full, but only reduces them.
If this risk reduction is assumed not only ex post but also ex ante for the expected return on equity, this is referred to as a so-called secure tax shield, otherwise the tax shield is uncertain.
The beta factor for secure Tax Shield
The beta factor for uncertain Tax Shield
Unsafe or secure tax shield?
Which of the two forms of beta calculation should be used depends largely on the way the valuation property is financed by equity and debt. In particular, managing the company towards a fixed debt ratio is not always possible only through a clever dividend policy, but also requires regular equity measures, e.g. in the form of share buybacks. In practice, this is more observable for listed companies in the Anglo-American region. On the German stock market, however, share buybacks are not a typical form of “dividend policy.” For the less fungible shares in a GmbH, this instrument is not available anyway or is only available to an extremely limited extent.
The most important thing: “Unlevers” and “Relevers” with the same formula or well documented!
Whether the decision “certain” or “uncertain” has significant effects depends primarily on how much the indebtedness ratio of the comparable companies — this is where unlevered — and the indebtedness ratio of the valuation object — here is to relevern. The higher the indebtedness ratio of the valuation property relative to the comparable companies, the more attenuated is the increase in the beta factor when using the “secure tax shield” with a corresponding positive effect on the determined company value.
More important than deciding for or against the secure tax shield, however, is to carry out both unlevers and relevers with the same approach, i.e. to assume either a secure or an insecure tax shield. Otherwise, there will be systematic errors, which are reinforced by the above-mentioned influence of the debt ratio. Only in well-justified cases, in which the debt policy of (then necessarily homogeneous) peer group and evaluation object differ in its structure, should the evaluator combine secure and uncertain tax shield in the case of unlevered and relevern.
And for the evaluator, knowledge of these relationships means that data sources that already offer, through no fault of their own, adjusted beta factors, but do not disclose any information on the type of adjustment, can only be worked to a limited extent or not at all. that SmartZebra beta factors module supports the efficient and professional calculation of beta factors for company valuations.