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The management of Drax Industries Moonraker Inc., a public company, is going to maintain a constant...

The management of Drax Industries Moonraker Inc., a public company, is going to maintain a constant D/E ratio in the long run. If you are to calculate the present value of the tax shields resulting from the use of debt financing, what discount rate will you use and why?

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Tax shield is Tax rate * Interest rate. To calculate the value of levered firm, value of interest tax shields must be added to the value of unlevered firm which arising because of the fact that debt brings tax savings.

The interest rate tax shields are discounted at the cost of debt.

This happens because market value of debt is known and debt is perfectly correlated with the value of interest tax savings (tax shields). Therefore, debt and tax shield are equally risky; thus both components are discounted at the same discount factor (cost of debt) to reflect the same level of risk present in both's existence.

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