Discount Rates and Tax

Abstract

Subject Areas: Corporate finance, taxes, cost of capital, capital expenditure, valuation analysis

This note summarises the relationships between values, rates of return and betas that depend on taxes. It extends the standard analysis to include the effect of risky debt. It brings together a variety of results that are often misunderstood or misinterpreted. Both the WACC and APV approaches are presented for a generalised tax system that encompasses both classical and imputation systems. It shows how basic assumptions about the tax treatment of the 'representative' investor, the firm's dividend policy, the firm's leverage policy and the riskiness of the tax savings from interest give rise to particular expression for leveraged and unleveraged betas and discount rates. Results for the Miller-Modigliani and Miles-Ezzell assumptions are summarised in detail and presented in a simple table.

JEL Classification: G31, G32, H25