Errors related to the beta factors can be avoided by paying attention to whether the tax shield is safe or unsafe.
Errors related to the beta factors can be avoided by paying attention to whether the tax shield is safe or unsafe.
When determining the beta factors, the question always arises: "How secure is the use of the tax advantage of debt financing?" It is important for the valuer to distinguish between the cash flow effect and the risk effect. In combination, these two effects define the amount of the often not insignificant value of the tax shield. A good understanding of the basics of the tax shield is therefore highly relevant for business valuation.
The tax shield refers to the tax advantage of debt financing due to the deductibility of interest from the tax assessment base. In Germany, this generally applies in full for corporation tax and 75% for trade tax. In many countries, interest on debt capital is even fully tax-deductible as part of taxation at company level.
This effect can be referred to as the cash flow effect of the tax shield. In the Income approach, it is taken into account directly in the income calculation. When using the DCF method, it is usually taken into account in the weighted average cost of capital (WACC) by reducing the borrowing costs by the amount of the exempt tax rate.
To understand the risk effect of the tax shield, it helps to first consider the effect of the leverage effect. Debt has a risk-increasing effect for equity providers because the interest burden does not vary, or does not vary completely, with the success of the company. If the cost of equity is higher than the cost of debt, the return and risk for equity providers increase with increasing gearing, not only in absolute terms but also in relative terms. The return on equity increases with a higher level of debt and vice versa.
In addition to the disadvantage of increasing risk for equity providers, additional Debt brings the advantage of an additional tax shield. In the leverage effect, the interest does not actually increase the risk in full, but only to a reduced extent.
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 safe tax shield, otherwise the tax shield is uncertain.
The beta factors for a secure tax shield
The beta factors for an uncertain tax shield
Insecure or secure tax shield?
Which of the two forms of beta calculation should be used depends largely on the way in which the valuation object is financed by equity and debt. It is not always possible to steer the company towards a fixed debt ratio by means of a clever dividend policy alone, but also requires regular equity measures, e.g. in the form of share buybacks. In practice, this is more common 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 only to a very limited extent.
Whether the decision "safe" or "unsafe" has a significant impact depends primarily on the extent to which the gearing of the peer companies - here unlevered - and the gearing of the valuation object - here levered - differ. The higher the gearing of the valuation object relative to the peer companies, the less pronounced the effect of the increase in the beta factors when applying the "safe tax shield", with a correspondingly positive effect on the calculated enterprise value.
It is more important than deciding for or against the safe tax shield to adopt the same approach for both unlever and relever, i.e. to assume either a safe or an unsafe tax shield. Otherwise, systematic errors will occur, which will be exacerbated by the aforementioned influence of gearing. Only in well-founded cases, in which the debt policy of the (then necessarily homogeneous) peer group and the valuation object differ in their structure, should the valuer combine a certain and an uncertain tax shield when unlevering and relevering.
The distinction between a secure and an uncertain tax shield is essential for the correct determination of the beta factors and thus for the valuation of the company value. While the cash flow effect of the tax shield describes the tax advantages of debt financing, the risk effect refers to the impact on the cost of equity and the return on equity. For a correct valuation, it is crucial to take both effects into account and to apply a consistent methodology.
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