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Tax‐Adjusted Discount Rates with Investor Taxes and Risky Debt
Author(s) -
Cooper Ian A.,
Nyborg Kjell G.
Publication year - 2008
Publication title -
financial management
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.647
H-Index - 68
eISSN - 1755-053X
pISSN - 0046-3892
DOI - 10.1111/j.1755-053x.2008.00016.x
Subject(s) - economics , tax shield , leverage (statistics) , debt , valuation (finance) , monetary economics , capital structure , discounting , cost of capital , econometrics , financial economics , microeconomics , tax reform , finance , public economics , state income tax , mathematics , profit (economics) , gross income , statistics
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 theSick (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 capital asset pricing model.