The Effect of Taxes on the Pricing of Defaultable Debt

• Main Authors: LIM, Kian Guan, SONG, Fenghua, WARACHKA, Mitchell Craig
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2003
• Subjects: Corporate Finance; Finance and Financial Management; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/4575; https://ink.library.smu.edu.sg/context/lkcsb_research/article/5574/viewcontent/The_Effect_of_Taxes_on_the_Pricing_of_Defaultable_Debt.pdf
• Institution: Singapore Management University

Empirical studies have documented the dependence of corporate credit spreads on default risk, equity premiums, and taxes. However, taxes have previously not been incorporated into reduced-form credit risk models. Therefore, we first extend the existing literature by considering a default intensity that depends on taxes as well as the default-free short rate and a market index. Consequently, we establish a theoretical basis to explain previous empirical findings regarding the significant impact of taxation on defaultable bond prices. Unlike previous models, tax implications for defaultable debt cannot be constructed from a sum of tax effects on zero coupon bonds. Our empirical tests then illustrate the importance of taxation. In particular, the impact of taxation increases as a function of the debt's maturity and coupon rate.