4. Tax Implications of Debt Financing

This section drops one of the key assumptions from the preceding section and studies in detail the tax implications of financing decisions. Debt receives favorable tax treatment compared to equity. By moving from equity financing to debt financing, firms can therefore save taxes, which provides them with an additional source of value on top of the value generated with the operating activities. 

We discuss the value implications of debt financing and show in detail how to compute the cost of capital of firms that pursue a financing policy with a target debt ratio (e.g., debt corresponds to 40% of firm value) or target debt levels (e.g., a fixed amount of debt outstanding). We then discuss a two-step valuation approach that allows us to adjust a company valuation to correctly reflect the tax implications of financing decisions. This is the so-called Adjusted Present Value (APV) approach. 

Ultimately, taxes lower the firm's borrowing cost. Instead of modelling the value implications of debt financing separately, we can also include the tax effect in the computation of the cost of capital. This is what the so-called Weighted Average Cost of Capital (WACC) does. We introduce this measure of the firm's cost of capital and show how to apply it in firm valuations.