Tax Shields in an LBO

In a typical LBO debt is reduced by a substantial part of the firm’s cash flow. The object of the paper is to analyze whether the tax advantages of this debt transaction plan can be evaluated using the APV or the WACC method. It turns out that none of them is appropriate, and we will provide a different approach using the theory of derivatives to value the tax shield. We compare our approach with WACC and APV and the finding is that the cost of debt are always less than the riskless interest rate.