Cost-of-Equity-Irrelevance Regarding Corporate Tax
Corporate Finance Review, Vol. 12, No. 3, pp. 21-25, November-December 2007
12 Pages Posted: 24 Feb 2008 Last revised: 16 Nov 2008
Abstract
In finance, it is taken for granted that cost of equity is a function of tax. This common sense misleads both MM (1963) and Hamada (1969) to propose the models of cost of equity after tax for MM (1958) and CAPM, respectively. This paper proves that cost of equity is irrelevant to tax. Otherwise, Double-Tax-Adjustment (DTA) will result. Payment to Equity After Tax is generally defined as (cost-of-equity)*(equity-value)*(1 - tax rate). In Proposition II, we prove generalized equity value after tax S = generalized equity value before tax Sg*(1 - tax rate). When equity value after tax covers tax-adjustment (1 - tax rate), there is no room for cost of equity to include any further tax-adjustment lest DTA results. Unfortunately, MM (1963) and Hamada (1969) are in the same boat in the use of the misleading symbol S for equity values before and after tax in their models of cost of equity and introduce a dummy cost of equity after tax by concluding that cost of equity is a function of tax for MM and CAPM, respectively. After revising MM (1963) and Hamada (1969), we have Cost of Equity Irrelevance regarding Tax (CEIT).
Keywords: Cost of equity before tax, cost of equity after tax
JEL Classification: G32
Suggested Citation: Suggested Citation
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