Thetaxrateusedhereisthefirm’smarginaltaxrateanditis
assumedtostayconstantovertime.Ifweanticipatethetax
rate changing over time, we canstill compute the present
value of tax benefits over time, but we cannot use the
perpetual growth equation cited earlier.
Estimating Expected Bankruptcy Costs and Net Effect
Thethirdstepistoevaluatetheeffectofthegivenlevelof
debt on the default risk of the firm and on expected
bankruptcy costs. In theory, at least, this requires the
estimation oftheprobability ofdefault with the additional
debtandthedirectandindirectcostofbankruptcy.Ifπaisthe
probabilityofdefaultaftertheadditionaldebtandBCisthe
presentvalue of the bankruptcy cost, thepresent value of
expected bankruptcy cost can be estimated.
This stepof theadjustedpresentvalueapproach posesthe
most significant estimation problem, since neither the
probability of bankruptcy nor the bankruptcy cost can be
estimated directly.
There are two basic ways in which the probability of
bankruptcycanbeestimatedindirectly.Oneistoestimatea
bondrating,aswedidinthecostofcapitalapproach,ateach
level of debt and use the empirical estimates of default
probabilitiesforeachrating.Forinstance,Table6.2,extracted
from a study by Altman and Kishore, summarizes the
probabilityofdefaultover 10 years bybondratingclassin
2000.