Valuation when bankruptcy is a possibility and taxes matter

Abstract

Purpose

This article aims to report the results of research into the effect of expanding the traditional models for valuation of simple securities to include the effect of taxation of the cash flows from investing and the possibility of bankruptcy of the issuer.

Design/methodology/approach

The models developed use the same techniques as the textbook models but lead to conclusions that are novel.

Findings

In particular, the models suggest that reducing the tax rate on capital gains does not always benefit bondholders and shareholders. For common stock the changes in both market value and realizable value depend not only on the change in tax rate, but also on the growth rate of the dividend stream.

Practical implications

The models presented follow the textbook models, so they assume stationary conditions. Future research should examine the case of conditions that may be mean‐reverting but are not stationary.

Originality/value

The immediate practical implications are in the domain of public policy, where the debate over the effect of tax changes has been based on overly simplified models.

Citation

Venezian, E.C. (2007), "Valuation when bankruptcy is a possibility and taxes matter", Journal of Risk Finance, Vol. 8 No. 3, pp. 230-245. https://doi.org/10.1108/15265940710750486