Tax-Adjusted Discount Rates with Investor Taxes and Risky Debt
21 Pages Posted: 5 Jun 2008
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Tax-Adjusted Discount Rates With Investor Taxes and Risky Debt
Tax-Adjusted Discount Rates with Investor Taxes and Risky Debt
Tax-Adjusted Discount Rates with Investor Taxes and Risky Debt
Date Written: January 2008
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: Tax adjusted discount rate, WACC
JEL Classification: G12, G31
Suggested Citation: Suggested Citation
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