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Tax-Adjusted Discount Rates with Investor Taxes and Risky Debt

Author

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  • Cooper, Ian
  • Nyborg, Kjell G

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.

Suggested Citation

  • Cooper, Ian & Nyborg, Kjell G, 2008. "Tax-Adjusted Discount Rates with Investor Taxes and Risky Debt," CEPR Discussion Papers 6646, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:6646
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    References listed on IDEAS

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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. 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.
    3. 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 161-196, March.
    4. 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.
    5. 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.
    6. 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.
    7. 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 1421-1460, December.
    8. 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.
    9. 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.
    10. 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.
    11. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-275, May.
    12. Deen Kemsley & Doron Nissim, 2002. "Valuation of the Debt Tax Shield," Journal of Finance, American Finance Association, vol. 57(5), pages 2045-2073, October.
    13. Merton H. Miller, 1991. "Tax Obstacles To Voluntary Corporate Restructuring," Journal of Applied Corporate Finance, Morgan Stanley, vol. 4(3), pages 20-23.
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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. repec:eee:quaeco:v:65:y:2017:i:c:p:346-354 is not listed on IDEAS
    3. Assaf Eisdorfer & Thomas J. O'Brien, 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.
    4. Peter MOLNAR & Kjell G. NYBORG, "undated". "Tax-Adjusted Discount Rates: A General Formula under Constant Leverage Ratios," Swiss Finance Institute Research Paper Series 11-17, Swiss Finance Institute.
    5. Lund, Diderik, 2009. "Marginal versus Average Beta of Equity under Corporate Taxation," Memorandum 12/2009, Oslo University, Department of Economics.
    6. Mukhlynina, Lilia & Nyborg, Kjell G, 2016. "The Choice of Valuation Techniques in Practice: Education versus Profession," CEPR Discussion Papers 11303, C.E.P.R. Discussion Papers.
    7. repec:spr:busres:v:11:y:2018:i:1:d:10.1007_s40685-017-0053-z is not listed on IDEAS
    8. Fischer, Marcel & Jensen, Bjarne Astrup, 2017. "The debt tax shield, economic growth and inequality," arqus Discussion Papers in Quantitative Tax Research 219, arqus - Arbeitskreis Quantitative Steuerlehre.
    9. 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.
    10. Francesco Cohen & Alessandro Fedele & Paolo M. Panteghini, 2016. "Corporate taxation and financial strategies under asymmetric information," Economia Politica: Journal of Analytical and Institutional Economics, Springer;Fondazione Edison, vol. 33(1), pages 9-34, April.
    11. repec:spt:fininv:v:6:y:2017:i:3:f:6_3_2 is not listed on IDEAS
    12. 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.
    13. Marko Volker Krause & Alexander Lahmann, 2016. "Reconsidering the appropriate discount rate for tax shield valuation," Journal of Business Economics, Springer, vol. 86(5), pages 477-512, July.

    More about this item

    Keywords

    tax adjusted discount rate; WACC;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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