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Valuation Effects of Taxes on Debt Cancellation

  • Standard models on firm valuation regard a simplified default setting, often not revealing relevant implicit assumptions. In this paper, we analyze the impact of risky debt and of taxes on a cancellation of indebtedness (COD) on tax savings. For the case of a taxation of a COD, we explicitly show that the risky components in the pricing equation of tax savings cancel out so that the tax shield pricing is similar to the case of risk-free tax savings. Furthermore, assuming no tax on a COD, we show the standard textbook equations for the tax shield, the Tax-adjusted discount rates and WACC subject to risky debt to be generally valid only for a pro-rata loss distribution between interest and principal payments. Using standard equations for the case of no taxes on a COD in case of a non-proportional loss distribution can lead to substantial misvaluations, which we illustrate with an example.

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Document Type:Article
Author:Alexander LahmannORCiD, Marko KrauseORCiD
Chairs and Professorships:Chair of Mergers & Acquisitions
Parent Title (German):The Quarterly Review of Economics and Finance
Year of Completion:2016
Page Number:28
Tag:Default Risk; Tax Savings; Tax Treatment of Default; Tax-Adjusted Discount Rates
In: The Quarterly Review of Economics and Finance, (2016), DOI: 10.1016/j.qref.2016.11.005
Content Focus:Academic Audience
Peer Reviewed:Yes
Rankings:VHB Ranking / B