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Debt policy, corporate taxes, and discount rates

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  • Grinblatt, Mark
  • Liu, Jun

Abstract

This paper applies the standard risk-neutral valuation framework to tax shields generated by dynamic debt policies. We derive a partial differential equation (PDE) for the value of the debt tax shield. For a class of dynamic debt policies that depend on the asset's free cash flows, value, and past performance, we obtain closed-form solutions for the PDE. We also derive the tax-adjusted cost of capital for free cash flows and analyze the conditions under which the weighted average cost of capital is an appropriate discount rate. Finally, we derive closed-form solutions for equity betas, which differ from the formulas that have traditionally been used to lever and unlever equity betas.

Suggested Citation

  • Grinblatt, Mark & Liu, Jun, 2008. "Debt policy, corporate taxes, and discount rates," Journal of Economic Theory, Elsevier, vol. 141(1), pages 225-254, July.
  • Handle: RePEc:eee:jetheo:v:141:y:2008:i:1:p:225-254
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    Cited by:

    1. 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.
    2. Rainer Baule, 2019. "The cost of debt capital revisited," Business Research, Springer;German Academic Association for Business Research, vol. 12(2), pages 721-753, December.
    3. Robert Couch & Michael Dothan & Wei Wu, 2012. "Interest Tax Shields: A Barrier Options Approach," Review of Quantitative Finance and Accounting, Springer, vol. 39(1), pages 123-146, July.
    4. Dirk Beyer, 2018. "A matrix approach to valuation and performance measurement based on accounting information considering different financing policies," Journal of Management Control: Zeitschrift für Planung und Unternehmenssteuerung, Springer, vol. 29(1), pages 37-61, March.
    5. Lin, Hsuan-Chu & Chou, Ting-Kai & Wang, Wen-Gine, 2012. "Capital structure and executive compensation contract design: A theoretical and empirical analysis," Journal of Banking & Finance, Elsevier, vol. 36(1), pages 209-224.
    6. Sven Arnold & Alexander Lahmann & Bernhard Schwetzler, 2018. "Discontinuous financing based on market values and the value of tax shields," Business Research, Springer;German Academic Association for Business Research, vol. 11(1), pages 149-171, February.
    7. Andrea Gamba & Gordon A. Sick & Carmen Aranda León, 2008. "Investment under Uncertainty, Debt and Taxes," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 37(1), pages 31-58, February.

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    JEL classification:

    • G0 - Financial Economics - - General
    • G1 - Financial Economics - - General Financial Markets

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