Valuation of tax loss carryforwards

Authors: Sudipto Sarkar

Publish Date: 2013/08/20

Volume: 43, Issue: 4, Pages: 803-828

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Abstract

Tax loss carryforwards TLC are a valuable asset because they can potentially reduce a company’s future tax payments However there is often a great deal of uncertainty regarding the probability and timing of these tax savings We propose a contingentclaim model to value this asset The value is determined primarily by the size of accumulated carryforwards relative to earnings We show that for poorly performing firms with large TLC 1 the realizable or fair value of the tax losses can be significantly smaller than the book value and 2 the tax losses can account for a significant fraction of the company’s equity value The model is illustrated by calibrating it to a couple of companies with large carryforwards Finally we show how the model can be used to compute the marginal tax rate of a company with carryforwardsFinancial support from the Social Science and Humanities Research Council SSHRC of Canada is gratefully acknowledged I would like to thank two anonymous referees for their helpful comments and suggestions and the Editor CF Lee for his recommendations during the review process The usual disclaimer appliesEquity value = VxL From Ito’s lemma we have textdV = text V textx textdx + 0 5 text V textxx left textdx right 2 + text V textL textdL the other terms drop out because dt2 = 0 dL2 = 0 and dt dL = 0From Ito’s lemma hboxdU = hboxU rm x hboxdx + 05 hboxU rm xx left hboxdx right2 = textUprime left hboxx rightleft mu hboxx hboxdt + sigma hboxx hboxdz right + 05text Uprime prime left hboxx right left sigma2 hboxx2 hboxdt right

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