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The Equity Trap, the Cost of Capital and the Firm’s Growth Path

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  • Tobias Lindhe
  • Jan Södersten

Abstract

This paper reconsiders Sinn’s (1991) nucleus theory of the corporation by comparing two different regimes for the equity trap. In the first of these, all cash paid to the shareholders is taxed as dividends, in the second, shareholders are allowed a tax-free return of capital contributed through new issues. A substantial difference is found between the regimes in the size of initial equity injections, although in both regimes, no dividends are paid until a new long-run equilibrium is reached. Contrary to Sinn, we find that with optimal behavior, the cost of new equity is lower than suggested by conventional formulae.

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File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2006/wp-cesifo-2006-09/cesifo1_wp1801.pdf
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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 1801.

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Date of creation: 2006
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Handle: RePEc:ces:ceswps:_1801

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Keywords: dividend taxation; equity trap; cost of capital; nucleus theory; growth path;

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  1. Alan J. Auerbach, 1980. "Wealth Maximization and the Cost of Capital," NBER Working Papers 0254, National Bureau of Economic Research, Inc.
  2. Auerbach, Alan J. & Hassett, Kevin A., 2003. "On the marginal source of investment funds," Journal of Public Economics, Elsevier, vol. 87(1), pages 205-232, January.
  3. Auerbach, Alan J., 2002. "Taxation and corporate financial policy," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 3, chapter 19, pages 1251-1292 Elsevier.
  4. Auerbach, Alan J, 1983. "Taxation, Corporate Financial Policy and the Cost of Capital," Journal of Economic Literature, American Economic Association, vol. 21(3), pages 905-40, September.
  5. Sinn, Hans-Werner, 1991. "The vanishing harberger triangle," Journal of Public Economics, Elsevier, vol. 45(3), pages 271-300, August.
  6. David F. Bradford, 1979. "The Incidence and Allocation Effects of a Tax on Corporate Distributions," NBER Working Papers 0349, National Bureau of Economic Research, Inc.
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Cited by:
  1. Tobias Lindhe & Jan Södersten, 2009. "Dividend Taxation, Share Repurchases and the Equity Trap," CESifo Working Paper Series 2652, CESifo Group Munich.
  2. Ågren, Martin, 2006. "Prospect Theory and Higher Moments," Working Paper Series 2006:24, Uppsala University, Department of Economics.

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