A Martingale Approach to Compute the Value of Debt Tax Shields

The recent interest in the valuation of tax benefits from debt arises from the disagreement in the existing literature about the meaning of “value of tax shields.” Although it is accepted that the value of a firm increases as effect of the tax deductibility of interest, the correct valuation of this extra-value is controversial. In this paper we adopt a risk-neutral approach to derive a general formula for the value of tax shields. We clearly show that this value must equal the summation of the discounted future tax savings, regardless of a specific leverage policy or a given cash flows pattern. Once we focus our formula specifying a financing policy and a cash flow dynamics, some well-known results are obtained. Also, the value of tax shields we achieve is coherent with the classic WACC valuation method, provided that the debt schedule is treated consistently. JEL classification: G12; G31; G32.