Interest Tax Shields: A Barrier Options Approach
26 Pages Posted: 19 Apr 2012 Last revised: 6 Jun 2013
Date Written: January 1, 2012
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: Suggested Citation