What Is the Risk of the Debt Tax Shield?
18 Pages Posted: 31 Dec 2019 Last revised: 6 Feb 2020
Date Written: February 5, 2020
What is the risk of the debt tax shield? Berk and DeMarzo (2017) argue that it is the same as the risk of the assets of the firm, under the assumption of a constant debt-to-value ratio. Ross et al. (2016), on the other hand, state that its the same as the risk of the debt. The assumptions imply two different formulas for the relation between the unlevered cost of capital and the equity and debt on the levered firm. In this note, I provide a counterexample to the claim that the risk of the tax shield equals the risk of the firm when the debt-to-value ratio is constant. I give a class of examples in which the risk of the tax shield is strictly between the risk of the debt and the risk of the firm, and discuss conditions under which the formula of Berk and DeMarzo (2017) will be a good approximation.
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