Comments Welcome Debt Policy, Corporate Taxes, and Discount Rates ∗†

Debt Policy, Corporate Taxes, and Discount Rates This paper studies the valuation of assets with debt tax shields when debt policy is a general time-dependent function of the asset’s unlevered cash flows, value, and history. In a continuous-time setting, it shows that the value of a project’s debt tax shield satisfies a partial differential equation, which simplifies to an easily solved ordinary differential equation for most plausible debt policies. A large class of cases exhibits closed-form solutions for the value of a levered asset, the value of its tax shield, and the appropriate cost of capital for discounting unlevered cash flows so as to account for the value of the tax shield. Perhaps the most popular application of financial theory is capital budgeting. Virtually every student of finance starts his education in the field by learning how to discount future cash flows. By the end of a first course, the student has developed the basic tools to imple-ment a discounted cash flow analysis in a real world setting. Because the real world setting must account for the relative advantage of debt financing, arising from the debt interes