DCF Valuation and Imputed Interest on Equity Increase - Implications of the Austrian Tax System in a Model with Stochastic Profitability

As early as the 1980s, several European countries implemented tax systems with imputed equity interest provisions. Since its tax reform in 2000, Austria has also allowed the deduction of (fictitious) imputed equity interest from the tax base. This paper integrates the resulting equity-related tax benefits into the valuation of corporations. Using the equity method with special attention to the deductibility of imputed equity interest, we calculate the value of a business in a multi-period model. We find that a market-to-book ratio endogenous to the model results. We then demonstrate how to apply the APV method in a model with imputed equity interest. For each business - and thus also for an unlevered company - an adjustment is necessary to account for the tax shield resulting from equity financing. Therefore, an unlevered company that does not use equity tax shields has to be chosen as a common denominator in the application of the APV method, in which a closed-form solution is presented for the value of this tax benefit. Finally, we derive a weighted average cost of capital that considers the deductibility of imputed equity interest. We show that an additional term correcting for equity tax shields is necessary