The cost of capital and its component parts with corporate and personal tax

Abstract

The purpose of this paper is to calculate the cost of capital, the cost of equity and the cost of debt in a world with corporate and personal taxes. We do this in a manner that is consistent with the calculation when there is no tax and when there is corporate tax only. Our results differ from most finance textbooks which either ignore the calculation or assume that the entire burden of personal tax is borne by the stockholders regardless of the level of tax on debt income. Specifically, in these texts the market value of debt remains constant and hence the decline in the value of the firm due to the imposition of personal tax on debt is paid by a matching reduction in shareholders equity. In addition, the approach in these texts can lead to a negative value of the firm and a decreasing cost of capital even when the personal tax on debt income exceeds the personal tax on stock income.