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.
Highlights
This paper derives a tax-adjusted discount rate formula with a constant proportion leverage policy, investor taxes, and risky debt
We contrast this with an alternative assumption that leads to the Sick (1990) result that these should be discounted at the riskless rate
According to Sick, the formula given by Brealey and Myers (2003) differs from his "... by the incorrect treatment of risky debt, as well as the failure to recognize that tax shields should be discounted at a cost of equity..."
Summary
We operate under the Miles and Ezzell (1980) leverage assumption that leverage is maintained at a constant proportion of the market value of the firm. The ME formula applies to any profile of cash flows as long as the company maintains constant market value leverage It provides a relationship between the leveraged discount rate, Ri, and the unleveraged rate, Rij. We analyze a firm with expected pre-tax cash flows C,, at dates t= 1 , . The original ME formula that relates Ru and RL was derived with an informal treatment of risky debt and no investor taxes. It is dependent upon the "cost of debt" where this could be interpreted either as the yield or the expected return. Equation (9) is the formula derived by Taggart ( 1991 ) when debt is riskless
Sign-in/Register to view highlights & summary Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
