Interest Tax Shields: A Barrier Options Approach
Published online: 30 March 2012
Ó Springer Science+Business Media, LLC 2012
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, sys-
tematic and business risk, risk-free interest rate, interest coverage ratio covenant, and the
ﬁrm’s reﬁnancing strategy.
Keywords Debt Á Tax shield Á Default Á Interest coverage Á Reﬁnancing Á
Leveraged buyout Á Barrier option
JEL classiﬁcation G13 Á G33
There is a link between barrier options and the value of tax shields of interest expense.
Interest tax shields are an important part of enterprise value, Kemsley and Nissim (2002)
estimate that, on average, the value of interest tax shields is 10 enterprise value.
We thank Fred Thompson, Nicole Thibodeau, an anonymous reviewer, and C.F. Lee, the editor of the
Review of Quantitative Finance and Accounting, for valuable comments.
R. Couch Á M. Dothan Á W. Wu (&)
Atkinson Graduate School of Management, Willamette University,
900 State St, Salem, OR 97301, USA
Rev Quant Finan Acc (2012) 39:123–146