DCF Business Valuation in Tax Regimes with Imputed Interest on the Stock of Equity

In the last two decades several European countries implemented tax systems that allow for the deduction of imputed equity interest from a company’s tax base. This paper integrates the tax benefits resulting from imputed interest on the stock of
equity into business valuation. Three alternative discounted cash flow valuation methods are used to this end: the equity method, the Adjusted Present Value (APV) method, and the entity method. Intertemporal differences in risk require the use of
various risk-adjusted discount rates in the equity method as well as the APV method. Using the equity method we show that the well-known, market-to-book ratio of the constant growth dividend discount model also holds in our model. When applying the APV method with imputed equity interest, an adjustment is necessary for each
business, also for an unlevered company, to account for the tax shield resulting from equity financing. A closed-form solution is presented for the value of this tax benefit. We furthermore derive the weighted average cost of capital (WACC) under imputed interest on the stock of equity and the adjustment of the cost of equity that is necessary to derive the WACC as a weighted average of cost of equity and debt.