Working Paper: CEPR ID: DP6646
Authors: Ian Cooper; Kjell G. Nyborg
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 Codes: G12; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| tax treatment of tax losses in default (H26) | valuation of tax shields (H25) |
| ME approach (C30) | tax savings from risky debt (G32) |
| Sick's 1990 approach (B51) | tax payments related to debt write-downs (H69) |
| differences in assumptions between ME and Sick's approaches (B51) | variations in discount rates (E43) |
| treatment of tax savings from debt (H20) | appropriate discount rate (H43) |