The cost of capital in the presence of alternative corporation and personal tax regimes
In 1958, Modigliani and Miller initiated an important debate in modern corporate finance literature, when they stated that in the absence of taxes, the cost of capital of a firm is independent of its capital structure. They modified and then corrected their view in 1963 when they stated that the introduction of corporation taxes into their model implied that there is a tax advantage to leverage and therefore taxes influenced the cost of capital. Subsequently, in the 1970s and 1980s, this debate has focused on the interaction of personal taxes and corporation taxes with the cost of capital and on the determination of whether taxes influence the cost of capital at all. This thesis contributes to this debate by addressing the following issues: (a) Do personal taxes matter at all for calculating the cost of capital. How sensitive is the influence of personal taxes to differences in the capital structure and pay out policies of the firms. (b) How can more realistic features of the tax code be incorporated in the determination of the cost of capital. (c) Taxation systems can be classified into 4 main types according to the degree of integration of personal and corporation taxes. These systems are the Classical, Imputation, Two-Rate and the Integrated systems. The cost of capital, in the presence of uncertainty as well as corporation and personal taxes, is derived for each of the above systems in this thesis. (d) Taxation systems can also be classified into 2 main types according to the taxable base used. These are the Comprehensive Income Tax and the Expenditure Tax systems. The cost of capital, in the presence of uncertainty as well as corporation and personal taxes, is derived under both the above regimes. (e) Application of the results of (a), (b) and (c) above to address practical issues such as using the cost of capital equation to determine the effect of changes introduced by the 1988 Budget on the cost of capital. (f) Application of the results of (d) above to contradict the claims made in the Meade Committee regarding the tax neutrality issue. A system that is tax neutral even when uncertainty is taken into account, is proposed. All the above issues have the common theme of the determination of the appropriate cost of capital in the presence of both uncertainty as well as corporation and personal taxes. The conclusions reached are stated at the end of the relevant chapters.