Tax-Adjusted Discount Rates With Investor Taxes and Risky Debt
London Business School Institute of Finance Paper
19 Pages Posted: 18 Oct 2004 Last revised: 26 Nov 2007
Date Written: September 2007
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 the Sick (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 CAPM.
Keywords: Capital structure, valuation, risky debt, cost of capital
JEL Classification: G31, G32
Suggested Citation: Suggested Citation