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Tax-Adjusted Discount Rates with Investor Taxes and Risky Debt

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Author Info
Cooper, Ian
Nyborg, Kjell G

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Abstract

This paper derives a tax-adjusted discount rate formula with a constant proportion leverage policy, investor taxes, and risky debt. The result depends on an assumption about the treatment of tax losses in default. We identify the assumption that justifies the textbook approach of discounting interest tax shields at the cost of debt. We contrast this with an alternative assumption that leads to the Sick (1990) result that these should be discounted at the riskless rate. These two approaches represent polar cases. Each generates its results by using a different simplifying assumption, and we explain what determines the correct treatment in practice. We also discuss implementation of the valuation procedure using the CAPM.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6646.

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Date of creation: Jan 2008
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Handle: RePEc:cpr:ceprdp:6646

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Keywords: tax adjusted discount rate; WACC;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Brian L. Betker, 1995. "An Empirical Examination of Prepackaged Bankruptcy," Financial Management, Financial Management Association, vol. 24(1), Spring.
  2. Rajan, Raghuram G & Zingales, Luigi, 1995. " What Do We Know about Capital Structure? Some Evidence from International Data," Journal of Finance, American Finance Association, vol. 50(5), pages 1421-60, December. [Downloadable!] (restricted)
    Other versions:
  3. Ian A. Cooper & Sergei A. Davydenko, 2007. "Estimating the Cost of Risky Debt," Journal of Applied Corporate Finance, Morgan Stanley, vol. 19(3), pages 90-95. [Downloadable!] (restricted)
  4. Gilson, Stuart C, 1997. " Transactions Costs and Capital Structure Choice: Evidence from Financially Distressed Firms," Journal of Finance, American Finance Association, vol. 52(1), pages 161-96, March. [Downloadable!] (restricted)
  5. Robert A. Taggart & Jr., 1991. "Consistent valuation and Cost of Capital Expressions With Corporate and Personal Taxes," Financial Management, Financial Management Association, vol. 20(3), Fall.
  6. Fernandez, Pablo, 2004. "The value of tax shields is NOT equal to the present value of tax shields," Journal of Financial Economics, Elsevier, vol. 73(1), pages 145-165, July. [Downloadable!] (restricted)
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  7. John R. Graham, 2000. "How Big Are the Tax Benefits of Debt?," Journal of Finance, American Finance Association, vol. 55(5), pages 1901-1941, October. [Downloadable!] (restricted)
  8. Deen Kemsley & Doron Nissim, 2002. "Valuation of the Debt Tax Shield," Journal of Finance, American Finance Association, vol. 57(5), pages 2045-2073, October. [Downloadable!] (restricted)
  9. Miles, James A. & Ezzell, John R., 1980. "The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life: A Clarification," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(03), pages 719-730, September. [Downloadable!]
  10. Benninga, Simon & Sarig, Oded, 2003. "Risk, returns, and values in the presence of differential taxation," Journal of Banking & Finance, Elsevier, vol. 27(6), pages 1123-1138, June. [Downloadable!] (restricted)
  11. Cooper, Ian A. & Nyborg, Kjell G., 2005. "The value of tax shields IS equal to the present value of tax shields," Discussion Papers 2005/14, Department of Finance and Management Science, Norwegian School of Economics and Business Administration. [Downloadable!]
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  12. Merton H. Miller, 1991. "Tax Obstacles To Voluntary Corporate Restructuring," Journal of Applied Corporate Finance, Morgan Stanley, vol. 4(3), pages 20-23. [Downloadable!] (restricted)
  13. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May. [Downloadable!] (restricted)
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  1. Cooper, Ian A. & Nyborg, Kjell G., 2005. "The value of tax shields IS equal to the present value of tax shields," Discussion Papers 2005/14, Department of Finance and Management Science, Norwegian School of Economics and Business Administration. [Downloadable!]
    Other versions:
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