Valuation and Dividend-Based Debt Policy

It is widely recognized in the field of corporate finance, when valuing a levered project or firm, that the debt tax shield adds value to the unlevered project or firm. However, the value of the tax shield remains subject of debate as Luehrman (1997) points out. Research studies have tended to focus on either the fixed debt policies of Modigliani and Miller (1963) or the value-based debt policies of Miles and Ezzell (1980).This paper introduces an innovative valuation model where the debt tax shield risk depends on dividends paid out. These are based on the Lintner (1956) dividend model. Two noteworthy implications of this debt policy arise. First, it corroborates that dividend policy and optimal investment are independent variables, whereas debt policy is treated as a dependent variable. Second, the applicable rate with which tax shields are discounted can be even smaller than the cost of debt. Hence, the value of such a tax shield is greater than that of a fixed debt policy