Cost of Capital when Dividends are Deductible

Abstract

Tax savings and the discount rate we use to calculate their value are involved in the calculation of cost of capital. Based on previous findings, we derive a general approach to cash flow valuation that take into account any kind of tax shields related to the financing decision of a firm and any date when they are earned. They can be used to introduce any type of externality that creates value through tax savings not captured by neither the cost of debt nor the cost of equity. This paper develops the formulations for the cost of capital when dividends, interest on equity or monetary correction of equity are deductible as it happens in Brazil. It shows that when properly done most known valuation methods are consistent and give identical results. Also, the paper argues that when dividends are tax deductible, optimal leverage is lower and equity value is higher.

Keywords

• Corporate Finance
• WACC
• interest on equity
• tax savings
• tax shields
• cost of equity
• discount rate for tax savings