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Tax-Adjusted Discount Rates with Investor Taxes and Risky Debt

Authors


  • We are grateful to an anonymous referee, Huang Wei Bin, and Bill Christie (the editor) for helpful suggestions. All remaining errors are ours.

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 theSick (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 capital asset pricing model.

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