2.1. Taxes and the Cost of Capital

Notice that in Equation 1 we adjust the expected before-tax cost on new debt financing, r_d, by a factor of (1 − t). In the United States and many other tax jurisdictions, the interest on debt financing is a deduction to arrive at taxable income. Taking the tax-deductibility of interest as the base case, we adjust the pre-tax cost of debt for this tax shield. Multiplying r_d by (1 − t) results in an estimate of the after-tax cost of debt.

For example, suppose a company pays €1 million in interest on its €10 million of debt. The cost of this debt is not €1 million because this interest expense reduces taxable income by €1 million, resulting in a lower tax. If the company is subject to a tax rate of 40 percent, this €1 million of interest costs the company (€1 million) (1 − 0.4) = €0.6 million because the interest reduces the company’s tax bill by €0.4 million. In this case, the before-tax cost of debt is 10 percent, whereas the after-tax cost of debt is (€0.6 million)/(€10 million) = 6 percent.

Estimating the cost of common equity capital is more challenging than estimating the cost of debt capital. Debt capital involves a stated legal obligation on the part of the company to pay interest and repay the principal on the borrowing. Equity entails no such obligation. Estimating the cost of conventional preferred equity is rather straightforward because the dividend is generally stated and fixed, but estimating the cost of common equity is challenging. There are several methods available for estimating the cost of common equity, and we discuss two in this reading. The first method uses the capital asset pricing model, and the second method uses the dividend discount model, which is based on discounted cash flows. No matter the method, there is no need to make any adjustment in the cost of equity for taxes because the payments to owners, whether in the form of dividends or the return on capital, are not tax-deductible for the company.