PDF Ebook Taxation, uncertainty, and the cost of equity
Traditionally the pre-tax cost of capital is a function of the interest rate and the tax system. However, uncertainty implies that the market’s required return is no single interest rate, but depends on risk. Different tax systems split risk differently between firm and government. Thus the required expected return after corporate taxes depends on the tax system. Expressions for this are derived, based on a CAPM-type model. The weighted average cost of capital is decreasing in the tax rate, even for fully equity financed projects. This effect can be substantial, but is neglected in much of the literature.
Much of the literature on the relationship between taxation and the cost of capital neglects uncertainty. The central relationship can then be written as p = c(r) (King and Fullerton (1984), p. 10), where r is the real market interest rate and p the real cost of capital, defined as a minimum pretax rate of return. King and Fullerton write that the function c “depends upon the details of the tax code,” and that one way of thinking about the condition is to consider r as given and ask how various tax systems affect p in various circumstances.
This approach is easily misleading under uncertainty. Different corporate tax systems split the risk between the firm and the government in different ways. There is not one general required expected rate of return after corporate tax which could play the role of r. An average will not do either. Instead one must consider how each tax system affects the risk characteristics of the after-corporate-tax cash flow. In particular, depreciation schedules, interest deductibility, and loss offset are important.
In the present paper it is assumed that the market requirements are represented by a Capital Asset Pricing Model (CAPM). But apart from this, the method is similar to considering r as given: It is a partial equilibrium analysis with fixed parameters of the CAPM.
The existing literature shows that it is possible to analyze corporate taxation under uncertainty with other methods, not relying on characterizing the risk of the net after-corporate-tax cash flow. Fane (1987) uses value additivity to arrive at neutrality results. Value additivity implies that the cash flow tax proposed by Brown (1948) is neutral. More-over, it allows for the following line of reasoning: With a Brown tax as a point of departure, one may postpone some deductions, such as depreciation, as long as their present value is maintained. The required interest accumulation is at the risk free interest rate as long as the tax value of the deductions is received with full certainty. No risk adjustment is needed in the rate.
This paper will instead consider the necessary risk adjustment — the beta in CAPM jargon — for the net after tax cash flow. This is done under similar assumptions as in Fane (1987), risk free deductions, but also under one alternative assumption with no loss offset. In principle these situations could be handled without considering the net cash flow. Each element of the cash flow could be handled separately.
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PDF Ebook Taxation, uncertainty, and the cost of equity
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