Tax-Adjusted Discount Rates: A General Formula under Constant Leverage Ratios

Kjell Nyborg and Molnár, Peter
Authors registered in the RePEc Author Service: Peter Molnár

No 8330, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: Cooper and Nyborg (2008) derive a tax-adjusted discount rate formula under a constant proportion leverage policy, investor taxes and risky debt. However, their analysis assumes zero recovery in default. We extend their framework to allow for positive recovery rates. We also allow for differences in bankruptcy codes with respect to the order of priority of interest payments versus repayment of principal in default, which may have tax consequences. The general formula we derive differs from that of Cooper and Nyborg when recovery rates in default are anticipated to be positive. However, under continuous rebalancing, the formula collapses to that of Cooper and Nyborg. We provide an explanation for why the effect of the anticipated recovery rate is not directly visible in the general continuous rebalancing formula, even though this formula is derived under the assumption of partial default. The errors from using the continuous approximation formula are sensitive to the anticipated recovery in default, yet small. The "cost of debt" in the tax adjusted discount rate formula is the debt?s yield rather than its expected rate of return.

Keywords: Cost of debt; Partial default; Personal taxes; Risky debt; Tax shields; Tax-adjusted discount rates (search for similar items in EconPapers)
JEL-codes: G31 G32 (search for similar items in EconPapers)
Date: 2011-04
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Working Paper: Tax-Adjusted Discount Rates: A General Formula under Constant Leverage Ratios (2011)
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