Pass-Through Valuation with Growth

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Hull, Robert M.
Washburn University. School of Business
Kaw Valley Bank
Issue Date
November 2018
Alternative Title
We build on the nongrowth pass-through capital structure model (CSM) research by adding growth and changes in tax rates. We begin by deriving CSM pass-through gain to leverage (GL) equations for nongrowth and growth when tax rates are a function of leverage. These equations enable us to compute debt choice, valuation, and leverage gain outputs. We offer the following findings when applying the CSM where leverage choices are tied to bond rating spreads and growth tests are limited to a long-run historical rate of growth. First, pass-throughs maximize firm value by achieving an upper medium grade bond. This holds for nongrowth, growth and all three market risk tests with an average optimal debt-to-firm value ratio (ODV) of 0.3077. Second, growth pass-throughs can attain greater value with higher bond ratings and lower ODVs if they can achieve growth at historical norms at these lower ODVs. They can also attain greater value with lower bond ratings if they can achieve growth above historical norms. Third, pass-through value is higher with growth compared to nongrowth except for the high market risk scenario. The greatest pass-through value enhancement from growth occurs for a low market risk scenario. Fourth, pass-throughs leave almost six percent on the table by remaining unlevered with this percentage showing only minor deviation based on nongrowth versus growth or market risk. Fifth, we repeat some of the prior nongrowth tests but allow for changes in tax rates in these tests. In doing this, we find that prior nongrowth findings hold when using the new tax code, more recent bond rating spreads, and three market risk scenarios. These prior nongrowth findings also hold with growth. In particular, comparisons of outputs for two tax rate schemes using growth are similar to the prior nongrowth research.