The Firm's Cost of Capital, its Effective Marginal Tax Rate, and the Value of the Government's Tax Claim

Berkeley Electronic Press, Topics in Economic Analysis and Policy, Vol. 6, No. 1, Article 3, 2006

Posted: 22 Feb 2006

See all articles by Eric C. Stevens

Eric C. Stevens

American Express TRS Co., Inc.

Ramesh K. S. Rao

University of Texas at Austin - Department of Finance

Abstract

This paper develops a theory of the firm's weighted average cost of capital (WACC) and the marginal tax rate with risky debt and potentially redundant depreciation and interest tax shields. The tax shields' risks, the firm's borrowing interest rate and its marginal tax rate are intertwined, and they must therefore be determined simultaneously. We capture these interdependencies by determining the borrowing interest rate endogenously, using the single-factor approximate arbitrage pricing theory. This research strategy: a) yields the correct discount rate for valuing the tax shields and shows how better WACC and marginal tax rate estimates can be generated, b) identifies the determinants of the firm's debt capacity in terms of asset characteristics and exogenous economic variables, and c) specifies, numerically, how policy variables (corporate tax rate, tax rules, and the T-bill rate) affect the market values of claims on the firm's output that are both private (debt, equity) and public (tax claims).

Keywords: Cost of capital, debt capacity, marginal tax rate, tax shield

JEL Classification: G12, G30, G31, G32, H20

Suggested Citation

Stevens, Eric C. and Rao, Ramesh K. S., The Firm's Cost of Capital, its Effective Marginal Tax Rate, and the Value of the Government's Tax Claim. Berkeley Electronic Press, Topics in Economic Analysis and Policy, Vol. 6, No. 1, Article 3, 2006. Available at SSRN: https://ssrn.com/abstract=882531

Eric C. Stevens

American Express TRS Co., Inc. ( email )

Phoenix, AZ 85021
United States

Ramesh K. S. Rao (Contact Author)

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-475-8756 (Phone)
512-471-5073 (Fax)

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