The Cost of Equity Capital at the Corporate and Investor Levels Allowing a Rational Expectations Model with Personal Taxations

Abstract

This paper argues that the conventional definition of the cost of equity at the corporate level is likely to be fundamentally flawed under conditions of personal taxation. A ‘dimensionally consistent’ definition is developed utilising the pioneering contributions of Auerbach and Elton and Gruber. Consequent benefits are straight‐forward expressions for the cost of equity capital at the corporate level (for both retained earnings and new equity) as well as at the investor level (post personal tax) in terms of both the dividend discount and CAPM‐type models, which are applicable to classical and imputation tax systems. A fundamental framework is thereby provided which succeeds in illuminating investor personal tax liabilities as they might be expected to impact on a firm's investment and related dividend policies.