Interest Tax Shields: A Barrier Options Approach

26 Pages Posted: 19 Apr 2012 Last revised: 6 Jun 2013

See all articles by Robert B. Couch

Robert B. Couch

Willamette University - Atkinson Graduate School of Management

Michael U. Dothan

Willamette University - Atkinson Graduate School of Management

Wei Wu

Cal Poly Pomona

Date Written: January 1, 2012

Abstract

There is a link between barrier options and tax shields of interest expense. We combine this link with a traditional valuation approach, to present practical valuation formulas for interest tax shields in three debt scenarios with risk of default: (1) constant debt, (2) delayed debt, and (3) debt refinancing. In all cases, default and refinancing are contingent on the random evolution of the income of the firm. For each scenario, we work out sensitivity analysis of the value of tax shields with respect to income, growth, systematic and business risk, risk-free interest rate, interest coverage ratio covenant, and the firm's refinancing strategy.

Keywords: debt, tax shield, default, interest coverage, refinancing, leveraged buyout, barrier option

JEL Classification: G13, G31, G33

Suggested Citation

Couch, Robert B. and Dothan, Michael U. and Wu, Wei, Interest Tax Shields: A Barrier Options Approach (January 1, 2012). Review of Quantitative Finance and Accounting, Vol. 39, No. 1, 2012. Available at SSRN: https://ssrn.com/abstract=2042288

Robert B. Couch

Willamette University - Atkinson Graduate School of Management ( email )

900 State Street
Salem, OR 97301
United States

Michael U. Dothan

Willamette University - Atkinson Graduate School of Management ( email )

900 State Street
Salem, OR 97301
United States
(503) 370-6440 (Phone)

Wei Wu (Contact Author)

Cal Poly Pomona ( email )

3801 W Temple Ave
Pomona, CA 91768
United States

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