How can the common practice of using a firm's overall cost of capital rather than its cost of debt as a discount rate when calculating the present value of tax savings be justified?

Question

Quizplus · Accepted Answer

A is a legitimate justification because as the firm grows larger and borrows more debt, its tax shelter will increase, which will result in a higher present value of tax savings. B is also a legitimate justification because tax savings are usually relatively small, and the difference between the firm's overall cost of capital and its cost of debt as a discount rate does not make a significant difference in the present value. Therefore, both A and B can be used to justify the common practice of using a firm's overall cost of capital instead of its cost of debt as a discount rate when calculating the present value of tax savings. Using a firm's overall cost of capital as the discount rate for tax savings can be justified because as the firm grows larger and borrows more debt, its tax shelter will also increase. Additionally, tax savings are usually relatively small, so the difference in the discount rate used may not make a significant impact on the present value. Therefore, both justifications in options A and B are valid.

How Can the Common Practice of Using a Firm's Overall