Cost of Capital When Dividends are Deductible

Brazilian Review of Finance, Vol. 9, No. 3, pp. 309-334, 2011

26 Pages Posted: 18 Jun 2009 Last revised: 22 Jun 2013

See all articles by Ignacio Velez-Pareja

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation

Julián Benavides Franco

Universidad ICESI - Finance; Universidad ICESI - Economics & Management

Date Written: December 24, 2009

Abstract

When calculating Tax Savings, TS we are confronted with a strange mix of accounting accrual and market value when involving TS in the calculation of the Weighted Average Cost of Capital, WACC or the Cost of Equity, Ke. Firms earn the right to TS once they accrue the interest expense and they actually earn the TS when taxes are paid.

Tax savings and the discount rate (y) we use to calculate their value are involved in the calculation of WACC and Ke. Textbook WACC formulation is a very special and unique case that is not typical. Based on previous findings, we derive a general approach to those formulas that take into account any kind of TS related to the financing decision of a firm and any date when the TS is earned. These formulations 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.

In this paper we develop the formulations for Ke, the cost of levered equity and the average cost of capital when dividends or interest on dividends are deductible. This is the case of Brazil.

We show that using the proper formulation the most known valuation methods, i) Firm value with Free Cash Flow and WACC for the FCF; ii) value with the Capital Cash Flow and WACC for the CCF; iii) equity value with the Cash Flow to Equity and Ke, the levered cost of equity plus debt; iv) Adjusted Present Value, APV are consistent and give identical results.

Keywords: WACC, interest on equity, tax savings, tax shields, cost of equity, deductible dividends, deductible interest on equity

JEL Classification: D61, G31, H43

Suggested Citation

Velez-Pareja, Ignacio and Benavides Franco, Julián, Cost of Capital When Dividends are Deductible (December 24, 2009). Brazilian Review of Finance, Vol. 9, No. 3, pp. 309-334, 2011. Available at SSRN: https://ssrn.com/abstract=1421509

Ignacio Velez-Pareja (Contact Author)

Grupo Consultor CAV Capital Advisory & Valuation ( email )

Ave Miramar # 18-93 Apt 6A
Cartagena
Colombia
+573112333074 (Phone)

HOME PAGE: http://cashflow88.com/decisiones/decisiones.html

Julián Benavides Franco

Universidad ICESI - Finance ( email )

Calle 18 #122-135
A.A. 25608
A.A. 25608 Cali
Colombia

Universidad ICESI - Economics & Management ( email )

Cali
Colombia

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