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Department of Business and Management Science, Norwegian School of Economics (NHH) Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)

No 2005/15:
Tax-adjusted discount rates with investor taxes and risky debt

Ian A. Cooper () and Kjell G. Nyborg ()

Abstract: This paper derives tax-adjusted discount rate formulas 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; value of tax shields; risky debt; cost of capital; WACC; (follow links to similar papers)

JEL-Codes: G12; G31; G32; M21; (follow links to similar papers)

20 pages, December 22, 2005, Revised September 20, 2007

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