Interest Tax Shields: A Barrier Options Approach

Original Research
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Abstract

There is a link between barrier options and tax shields of interest expense. We combine this link with a traditional valuation approach, to present practical valuation formulas for interest tax shields in three debt scenarios with risk of default: (1) constant debt, (2) delayed debt, and (3) debt refinancing. In all cases, default and refinancing are contingent on the random evolution of the income of the firm. For each scenario, we work out sensitivity analysis of the value of tax shields with respect to income, growth, systematic and business risk, risk-free interest rate, interest coverage ratio covenant, and the firm’s refinancing strategy.

Keywords

Debt Tax shield Default Interest coverage Refinancing Leveraged buyout Barrier option 

JEL classification

G13 G33 
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Copyright information

© Springer Science+Business Media, LLC 2012

Authors and Affiliations

  1. 1.Atkinson Graduate School of ManagementWillamette UniversitySalemUSA

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