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.
Corporate Finance | Finance and Financial Management | Portfolio and Security Analysis
Journal of Risk Research
Incisive Financial Publishing
LIM, Kian Guan; SONG, Fenghua; and WARACHKA, Mitchell Craig.
The Effect of Taxes on the Pricing of Defaultable Debt. (2003). Journal of Risk Research. 6, (2), 1-29. Research Collection Lee Kong Chian School Of Business.
Available at: http://ink.library.smu.edu.sg/lkcsb_research/4575