A Closer Look at Leverage, Corporate Taxes and the Cost of Capital

16 Pages Posted: 24 Apr 2023

See all articles by John C. Handley

John C. Handley

University of Melbourne - Department of Finance

Date Written: April 12, 2023

Abstract

It is widely known that leverage reduces the cost of capital of a firm in a perfect capital market save for corporate income taxes. This result, however, rests on a cost of capital measure which is not fit for this purpose. When the correct measure is used, we find that leverage reduces the after-tax cost of capital only if the interest tax shields reduce the risk of the firm. This means that the after-tax cost of capital of a firm is independent of leverage if the firm adopts a leverage policy based on a target debt-value leverage ratio.

Keywords: Cost of capital; leverage; interest tax shield; valuation; leasing

JEL Classification: G31; G32

Suggested Citation

Handley, John C., A Closer Look at Leverage, Corporate Taxes and the Cost of Capital (April 12, 2023). Available at SSRN: https://ssrn.com/abstract=4416854 or http://dx.doi.org/10.2139/ssrn.4416854

John C. Handley (Contact Author)

University of Melbourne - Department of Finance ( email )

Victoria
Parkville, Victoria 3010 3010
Australia
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(61) 3 8344 6914 (Fax)

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