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Taxation, Uncertainty, and the Cost of Equity

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  • Diderik Lund

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Abstract

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. Copyright Kluwer Academic Publishers 2002

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File URL: http://hdl.handle.net/10.1023/A:1016576305306
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Article provided by Springer in its journal International Tax and Public Finance.

Volume (Year): 9 (2002)
Issue (Month): 4 (August)
Pages: 483-503

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Handle: RePEc:kap:itaxpf:v:9:y:2002:i:4:p:483-503
Contact details of provider: Web page: http://www.springerlink.com/link.asp?id=102915

Keywords: corporate tax; depreciation schedule; weighted average cost of capital; cost of equity; uncertainty;

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  1. Constantinides, George M, 1978. "Market Risk Adjustment in Project Valuation," Journal of Finance, American Finance Association, vol. 33(2), pages 603-16, May.
  2. Graham, John R. & Harvey, Campbell R., 2001. "The theory and practice of corporate finance: evidence from the field," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 187-243, May.
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  8. Green, Richard C & Talmor, Eli, 1985. " The Structure and Incentive Effects of Corporate Tax Liabilities," Journal of Finance, American Finance Association, vol. 40(4), pages 1095-114, September.
  9. Fane, G., 1987. "Neutral taxation under uncertainty," Journal of Public Economics, Elsevier, vol. 33(1), pages 95-105, June.
  10. Lawrence H. Summers, 1987. "Investment Incentives and the Discounting of Depreciation Allowances," NBER Chapters, in: The Effects of Taxation on Capital Accumulation, pages 295-304 National Bureau of Economic Research, Inc.
  11. Peter Sørensen, 1994. "From the global income tax to the dual income tax: Recent tax reforms in the Nordic countries," International Tax and Public Finance, Springer, vol. 1(1), pages 57-79, February.
  12. Lund, Diderik, 2006. "Valuation, leverage and the cost of capital in the case of depreciable assets," Working Papers 03-2003, Copenhagen Business School, Department of Economics.
  13. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  14. Heaps, Terry & Helliwell, John F., 1985. "The taxation of natural resources," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 1, chapter 8, pages 421-472 Elsevier.
  15. David Laughton, 1998. "The Management of Flexibility in the Upstream Petroleum Industry," The Energy Journal, International Association for Energy Economics, vol. 0(Number 1), pages 83-114.
  16. Saman Majd & Stewart C. Myers, 1987. "Tax Asymmetries and Corporate Income Tax Reform," NBER Chapters, in: Taxes and Capital Formation, pages 93-96 National Bureau of Economic Research, Inc.
  17. Paul G. Bradley, 1998. "On the Use of Modern Asset Pricing for Comparing Alternative Royalty Systems for Petroleum Development Projects," The Energy Journal, International Association for Energy Economics, vol. 0(Number 1), pages 47-81.
  18. Lund, D., 1990. "Petroleum Taxation under Uncertainty-Contingent Claims Analysis with an Application to Norway," Memorandum 24/1990, Oslo University, Department of Economics.
  19. Paul A. Samuelson, 1964. "Tax Deductibility of Economic Depreciation to Insure Invariant Valuations," Journal of Political Economy, University of Chicago Press, vol. 72, pages 604.
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Cited by:

  1. Peter Birch Sørensen, 2003. "Neutral Taxation of Shareholder Income: A Norwegian Tax Reform Proposal," CESifo Working Paper Series 1036, CESifo Group Munich.
  2. Peter Birch Sørensen, 2003. "Neutral Taxation of Shareholder Income: A Norwegian Tax Reform Proposal," EPRU Working Paper Series 03-06, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics.
  3. Lund, Diderik, 2006. "Taxation and systematic risk under decreasing returns to scale," Working Papers 02-2003, Copenhagen Business School, Department of Economics.
  4. Lund, Diderik, 2006. "Valuation, leverage and the cost of capital in the case of depreciable assets," Working Papers 03-2003, Copenhagen Business School, Department of Economics.
  5. Michael P. Devereux, 2009. "Taxing Risky Investment," Working Papers 0919, Oxford University Centre for Business Taxation.
  6. Peter Sørensen, 2005. "Neutral Taxation of Shareholder Income," International Tax and Public Finance, Springer, vol. 12(6), pages 777-801, November.

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