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Valuation of highly leveraged transactions:the impact of taxes and choice of financing

Awarded: NOK 0.30 mill.

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2007 - 2009

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High levels of leverage are increasingly used in LBOs, MBOs, project finance, going-private transactions and corporate restructurings. The valuation of the equity in these transactions can be approached in a several ways. Some involve estimating the enter prise value and then subtracting the value of the debt. Others involve valuing the equity directly from the equity cash flows. The latter approach tends to be favoured in practice, because it focuses directly on the cash flows that will be received by t he equity investors in the project. However, it involves the complexity that the required return on equity changes as the amount of leverage changes during the life of the investment and includes significant tax effects. The standard way to deal with this is to use a cost of equity that varies along with the changing degree of leverage as the project goes through its life. The formula that one uses to adjust the cost of equity for changing leverage depends on the precise leverage policy that the firm is pursuing. The standard assumption is that the policy is to maintain an amount of leverage that is proportional to the value of the firm. However, the point of many highly leveraged transactions is to have high leverage only initially. This difference can make a significant difference to the valuation of the tax saving from interest. Since this tax saving is a major motivation of highly leveraged transactions, misvaluation of this component can have a significant impact on the evaluation of these transact ions and thus on the use of capital. The purpose of the research is to develop an improved approach to valuing highly leveraged transactions that handles taxes properly. We will also take care to properly incorporate the risk of default. The approach wil l be based on the flows to equity method. We will consider a variety of tax codes and assess changes in values brought about by realistic changes to the tax code. An example is the recent tax changes in Norway