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Tax-adjusted discount rates with investor taxes and risky debt

Author

Listed:
  • 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.

Suggested Citation

  • Cooper, Ian A. & Nyborg, Kjell G., 2005. "Tax-adjusted discount rates with investor taxes and risky debt," Discussion Papers 2005/15, Norwegian School of Economics, Department of Business and Management Science, revised 20 Sep 2007.
    • Handle: RePEc:hhs:nhhfms:2005_015
    as

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    File URL: http://hdl.handle.net/11250/163566
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    References listed on IDEAS

    as
    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.
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    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, June.
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Capital structure; value of tax shields; risky debt; cost of capital; WACC;
    All these keywords.

    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
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • M21 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Economics - - - Business Economics

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