Corporation Income Taxes and the Cost of Capital: A Revision

19 Pages Posted: 25 Nov 2010 Last revised: 1 Jun 2013

James W. Kolari

Texas A&M University, Department of Finance

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation

Date Written: November 25, 2010

Abstract

The value of debt tax shields in foundational corporate valuation models by Nobel Laureates Modigliani and Miller (MM) continues to be a controversial issue that is central to our understanding of corporate finance. This paper argues that a fundamental valuation problem exists in the MM tax models. To overcome this problem, we propose a revision to their now famous tax correction model that yields much smaller tax gains on debt usage. Rather than discounting tax shields from debt interest payments using a riskless interest rate or unlevered equity rate, due to implausible valuation results implicit in this approach, the levered cost of equity is employed. Assuming no bankruptcy risk and no personal taxes, the proposed revised tax model yields an inverted U-shaped firm value function with an interior optimal capital structure. Analyses are extended to Miller’s personal tax extension of MM’s tax model. Also, implications to corporate capital structure decisions and previous literature are discussed.

Keywords: Value of Tax Shields, Capital Structure, Firm Valuation, Share Valuation

JEL Classification: G12, G31, G32

Suggested Citation

Kolari, James W. and Velez-Pareja, Ignacio, Corporation Income Taxes and the Cost of Capital: A Revision (November 25, 2010). Innovar, 22(46), 53-72. 2012; Mays Business School Research Paper No. 2012-31. Available at SSRN: https://ssrn.com/abstract=1715044 or http://dx.doi.org/10.2139/ssrn.1715044

James W. Kolari (Contact Author)

Texas A&M University, Department of Finance ( email )

MS-4218
Department of Finance
College Station, TX TX 77843-4218
United States
979-845-4803 (Phone)
979-845-3884 (Fax)

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation ( email )

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

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