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Adjustment of the WACC with Subsidized Debt in the Presence of Corporate Taxes: the N-Period Case

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  • Ignacio Vélez-Pareja
  • Joseph Tham
  • Viviana Fernández

Abstract

In the standard Weighted Average Cost of Capital (WACC) applied to the free cash flow (FCF), we assume that the cost of debt is the market, unsubsidized rate. With debt at the market rate and perfect capital markets, debt only creates value in the presence of taxes through the tax shield. In some cases, the firm may be able to obtain a loan at a rate that is below the market rate. In a previous work, we showed how to adjust the WACC in the presence of a subsidy and no taxes. There, we showed that plugging the lower (subsidized) cost of debt into the WACC formula is not the correct approach to measuring the value creation due to the subsidy. With subsidized debt and taxes, there would be a benefit to debt financing, and the unleveraged and leveraged values of the cash flows would be unequal. The benefit of lower tax savings are offset by the benefit of the subsidy. These two benefits have to be introduced explicitly. How would we adjust the WACC to take account of the subsidized debt? And how would we adjust the expression for the required return to leveraged equity? In this paper, using a multiple period example we present the adjustments to the WACC with subsidized debt and taxes. We demonstrate the analysis for both the WACC applied to the FCF and the WACC applied to the capital cash flow (CCF). We use the calculation of the Adjusted Present Value, APV, to consider both, the tax savings and the subsidy. We show how all the methods match.

Suggested Citation

  • Ignacio Vélez-Pareja & Joseph Tham & Viviana Fernández, 2005. "Adjustment of the WACC with Subsidized Debt in the Presence of Corporate Taxes: the N-Period Case," Proyecciones Financieras y Valoración 1945, Master Consultores.
    • Handle: RePEc:col:000463:001945
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    References listed on IDEAS

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    1. Ignacio Vélez-Pareja, 2007. "Cash Flow Valuation in an Inflactionary World. The Case of World Bank for Regulated Firms," Economic Analysis Working Papers (2002-2010). Atlantic Review of Economics (2011-2016), Colexio de Economistas de A Coruña, Spain and Fundación Una Galicia Moderna, vol. 6, pages 1-19, November.
    2. Ignacio Velez-Pareja & Joseph Tham, 2005. "Proper Solution of Circularity in the Interactions of Corporate Financing and Investment Decisions: A Reply to the Financing Present Value A," Proyecciones Financieras y Valoración 3395, Master Consultores.
    3. Joseph Tham & Ignacio Velez-Pareja Velez-Pareja, 2005. "With Subsidized Debt How do we Adjust the WACC?," Proyecciones Financieras y Valoración 3783, Master Consultores.
    4. Tham, Joseph & Velez-Pareja, Ignacio, 2004. "Principles of Cash Flow Valuation," Elsevier Monographs, Elsevier, edition 1, number 9780126860405.
    5. Ignacio Vélez-Pareja, 2004. "Modeling the Financial Impact of Regulatory Policy: Practical Recommendations and Suggestions. The Case of World Bank," Proyecciones Financieras y Valoración 3228, Master Consultores.
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    More about this item

    Keywords

    Adjusted Present Value; APV;

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis

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