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Tax-adjusted discount rates with investor taxes and risky debt

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  • Cooper, Ian A.

    ()
    (London Business School)

  • Nyborg, Kjell G.

    ()
    (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)

Abstract

This paper derives tax-adjusted discount rate formulas 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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Bibliographic Info

Paper provided by Department of Business and Management Science, Norwegian School of Economics in its series Discussion Papers with number 2005/15.

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Length: 20 pages
Date of creation: 22 Dec 2005
Date of revision: 20 Sep 2007
Handle: RePEc:hhs:nhhfms:2005_015

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Postal: NHH, Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway
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Fax: +47 55 95 96 50
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Web page: http://www.nhh.no/en/research-faculty/department-of-business-and-management-science.aspx
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Keywords: Capital structure; value of tax shields; risky debt; cost of capital; WACC;

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References

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  1. Brian L. Betker, 1995. "An Empirical Examination of Prepackaged Bankruptcy," Financial Management, Financial Management Association, vol. 24(1), Spring.
  2. 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.
  3. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
  4. 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.
  5. Cooper, Ian A. & Nyborg, Kjell G., 2006. "The value of tax shields IS equal to the present value of tax shields," Journal of Financial Economics, Elsevier, vol. 81(1), pages 215-225, July.
  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.
  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.
  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.
  9. 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.
  10. 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.
  11. Merton H. Miller, 1991. "Tax Obstacles To Voluntary Corporate Restructuring," Journal of Applied Corporate Finance, Morgan Stanley, vol. 4(3), pages 20-23.
  12. 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.
  13. 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.
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Cited by:
  1. Andrea Gamba & Leon Gordon & Carmen Aranda Leon, 2008. "Investment Under Uncertainty, Debt and Taxes," Working Papers wpn08-03, Warwick Business School, Finance Group.
  2. Molnár, Peter & Nyborg, Kjell G, 2011. "Tax-Adjusted Discount Rates: A General Formula under Constant Leverage Ratios," CEPR Discussion Papers 8330, C.E.P.R. Discussion Papers.
  3. Christian Koziol, 2014. "A simple correction of the WACC discount rate for default risk and bankruptcy costs," Review of Quantitative Finance and Accounting, Springer, vol. 42(4), pages 653-666, May.
  4. Cooper, Ian & Nyborg, Kjell G, 2005. "The Value of Tax Shields IS Equal to the Present Value of Tax Shields," CEPR Discussion Papers 5182, C.E.P.R. Discussion Papers.
  5. Assaf Eisdorfer, 2012. "The firm-specific nature of debt tax shields and optimal corporate investment decisions," Managerial Finance, Emerald Group Publishing, vol. 38(6), pages 560-570, May.
  6. Francesco Cohen & Alessandro Fedele & Paolo Panteghini, 2014. "Corporate Taxation and Financial Strategies Under Asymmetric Information," CESifo Working Paper Series 4772, CESifo Group Munich.

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