ratios,whichareweightedtogenerateaZ-Score.Theratios
used and their relative weights are usually based on past
historyon defaultedfirms. Thesecondstep istorelatethe
levelofthescoretoabondrating,muchaswehavedonein
Table 2.4 with interest coverage ratios. In making this
extension, though, note that complexity comes at a cost.
WhilecreditorZ-Scoresmay,infact,yieldbetterestimates
of synthetic ratings than those based only upon interest
coverageratios,changesinratingsarisingfromthesescores
are much more difficult to explain than those based on
interest coverage ratios. That is the reason we prefer the
flawed ratings that we get from interest coverage ratios.
Estimating the Tax Advantage
Interestistaxdeductibleandtheresultingtaxsavingsreduce
the cost of borrowing to firms. In assessing this tax
advantage, we should keep in mind that interest expenses
offsetthemarginaldollarofincome,andthetaxadvantage
therefore has to be calculated using the marginal tax rate.
Estimating themarginal taxrate, which is thetax rate on
marginal income (or the last dollar of income), can be
problematicbecausefirmsseldomreportitintheirfinancials.
Mostfirmsreportaneffectivetaxrateontaxableincomein
their annual reports and filings with the Securities and
Exchange Commission (SEC). This rate is computed by
dividingthetaxespaidbythenettaxableincomereportedin
thefinancialstatement.Theeffectivetaxratecanbedifferent
from the marginal tax rate for several reasons: