Value of tax benefits of a dynamic debt policy with regime switching

ABSTRACT

The article presents a method for valuation of stochastic future income with three barriers: a default barrier, a pre-default barrier and a refinancing barrier. Between the pre-default and default barriers, there is an ongoing cost of financial distress. In this framework, we derive state-dependent present value factors that can be applied to problems of valuation of firms, optimal financial structure and mitigation of agency conflicts between managers and investors. We illustrate our method with an analysis of the value of tax benefits of a dynamic debt policy.

KEYWORDS:

• Regime switching
• dynamic debt policy
• tax benefits
• bankruptcy costs
• agency conflicts
• refinancing

JEL CLASSIFICATION:

• D92
• G13
• G32
• G33.

Acknowledgment

The authors thank Steven E. Henson, Michael O’Connor Keefe and Fred Thompson for helpful comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the authors.

Additional information

Notes on contributors

Michael Dothan

Michael Dothan is Guy F. Atkinson professor of economics and finance at Willamette University. His research interests include finance and strategy, private and public financial engineering.

Wei Wu

Wei Wu is assistant professor of finance in the Department of Finance, Real Estate, and Law at California State Polytechnic University, Pomona. His researh interests span credit risk, fixed income markets, and asset pricing.