Cost of capital and valuation in the public and private sectors: Tax, risk and debt capacity

Abstract

AbstractCost of capital and valuation differ in the private and public sectors, because taxes are a cost to the private sector but are only a transfer to the public sector. We show how to transform the after‐tax private sector cost of capital into its pre‐tax equivalent, for comparison with the public sector cost of capital. We establish the existence of a tax induced wedge between these two costs of capital. The wedge introduces a preference on the part of the private sector for assets with rapid tax depreciation, high debt capacity and low risk. We show that, in circumstances where an asset has identical public and private sector valuation in the absence of taxes, the tax induced difference in valuation is identical to the change in government tax receipts that results from having the asset owned by the private rather than the public sector. We provide some examples of distortions that result from failure to adjust for changes in tax revenues, and show how to effect such adjustment.