Scandinavian Working Papers in Economics

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

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

Ian A. Cooper () and Kjell G. Nyborg ()
Additional contact information
Ian A. Cooper: London Business School, Postal: London Business School, Regent's Park, London , NW1 4SA, United Kingdom
Kjell G. Nyborg: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway

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

JEL-codes: G12; G31; G32; M21

20 pages, First version: December 22, 2005. Revised: September 20, 2007. Earlier revisions: September 20, 2007.

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