An Option Valuation Analysis of the Value of Tax Shields for Risky Debt

Abstract

Several different models for the appropriate discount rate for the tax shields and the present value of the tax shields resulting from the use of debt have appeared in the finance literature. This research uses an option valuation framework to develop models for the appropriate discount rate for the risky tax shields, the present value of the tax shields, and the probability of default resulting from the use of debt. Relationships between cash flows and their present values for firms with constant, perpetual growth are developed. The reinvestment required to support the constant, perpetual growth is incorporated in the expressions for the relationships between cash flows and present values. This analysis using option valuation theory and relationships between cash flows and their present values provides a framework for unifying the major apparently dissimilar results for the appropriate discount rate for the tax shields and the present value of the tax shields that have appeared in the finance literature.