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Discounting Debt Tax Shields at the Levered Cost of Equity

By James W. Kolari

Abstract

The value of debt tax shields in foundational valuation models by Nobel Laureates Modigliani and Miller (MM) continues to be a controversial issue that is central to our understanding of corporate finance. This paper contributes to this pivotal debate by proposing that the appropriate discount rate to value interest tax deductions available to levered shareholders is the levered cost of equity, rather than riskless and risky costs of debt or the unlevered cost of equity in previous studies. Assuming no bankruptcy risk and no personal taxes, the proposed revised tax model yields the following results that are more consistent with MM’s original tax model than their later corrected tax model. Implications to corporate capital structure decisions and previous literature are discussed. Also, analyses are extended to Miller’s personal tax extension of the MM model

Topics: Value of tax shields, Capital structure, Firm valuation, Share valuation
Year: 2011
OAI identifier: oai:CiteSeerX.psu:10.1.1.192.5456
Provided by: CiteSeerX
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