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

See all articles by Ian A. Cooper

Ian A. Cooper

London Business School

Kjell G. Nyborg

University of Zurich - Department of Banking and Finance; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Multiple version iconThere are 3 versions of this paper

Date Written: September 2007

Abstract

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

Cooper, Ian Anthony and Nyborg, Kjell G., Tax-Adjusted Discount Rates With Investor Taxes and Risky Debt (September 2007). London Business School Institute of Finance Paper, Available at SSRN: https://ssrn.com/abstract=605581 or http://dx.doi.org/10.2139/ssrn.605581

Ian Anthony Cooper (Contact Author)

London Business School ( email )

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+44 171 262 5050 (Phone)

Kjell G. Nyborg

University of Zurich - Department of Banking and Finance ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland
+41 (0)44 634 2980 (Phone)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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