THE COST OF EQUITY CAPITAL WITH PERSONAL INCOME TAXES AND FLOTATION COSTS

Abstract

THIS PAPER ESTABLISHES the cost of retention-financed capital and the cost of stock-financed capital in the presence of personal income taxes and flotation costs under alternative theories of share valuation that are considered plausible. In the absence of the tax and flotation costs (and information content to the dividend), the cost of equity capital is independent of its source. It then depends on whether a share's yield is independent of (SYI) or is dependent on (SYD) the firm's investment decision. It also depends on whether the return on investment functions in future periods are independent of (RIFI) or are dependent on (RIFD) the firm's current investment decision. Consequently, under the conditions stated there are four possible answers to the question, what is a corporation's cost of equity capital? Each of the pairs (1) SYI-RIFI, (2) SYD-RIFI, (3) SYI-RIFD, and (4) SYD-RIFD results in a different answer. Part I reviews these four solutions to the cost of equity capital. Part II extends the four solutions to establish the costs of retention-financed and stock-financed capital in the presence of flotation costs and the differential tax treatment of dividends and capital gains. Part III compares the results obtained with the existing literature. All that a search of the literature could find is the Lewellen [6] solution to the problem. That solution was confined to the SYI-RIFI case, and it assumed the pre-tax share yield is independent of the firm's investment decision. In fact, when the no-tax share yield is taken to be independent of the firm's investment decision, it is the after-tax share yield that takes on this property. The pre-tax share yield becomes a decreasing function of the dividend's rate of growth, and the Lewellen solution materially understates the costs of retention-financed and stock-financed capital under the SYI-RIFI assumptions. I. The cosft of equity capital depends on whether the return on investment functions in future periods are dependent on (RIFD) or independent of (RIFI) the firm's current investment decisions. We will first examine the cost of equity capital models under each of these assumptions in the absence of personal taxes and flotation costs.