Financing and Valuation of a Marginal Project by a Firm Facing Various Tax Rates

Abstract

A multinational firm operating under various tax regimes can minimize the total after-tax cost of its debt by allocating it optimally between its projects. To value a marginal project in this context, we build a multi-period model for the selection of projects, assuming that the firm maintains a target debt ratio on a firm-wide basis. To define a project's adjusted present value, we successively adopt the Miles-Ezzell analysis and the Harris-Pringle analysis. We show that a project's net present value results from the addition of two sums of cash flows discounted at the firm's (marginal) after-tax WACC: the sum of the discounted expected after-tax operating cash flows and a sum of discounted differences in expected interest tax shields (multiplied by a simple adjustment factor in the Miles-Ezzell case). This valuation formula extends the field of application of the standard WACC method, since it can be applied to a project whose debt ratio differs from the firm's target debt ratio.

Keywords: Interest Tax Shields, Adjusted Present Value, WACC, Debt Allocation, Debt Ratio

JEL Classification: G31, G32, C61