This paper is concerned with the impact which the tax-deductibility of interest payments has on the investment discount rate. It is widely assumed that the debt component of the overall cost of capital should reflect the tax privileges enjoyed by debt, that is that the cost of debt Ki should be reduced to Ki(1 -t), where t = the corporate tax rate. It will be argued that this definition is no more than an arithmetic device which is not only misleading but which fails to measure correctly the benefits of the tax savings. It is the cash flows and not Ki which should be adjusted to take account of the tax privileges of debt.There is lack of agreement as to the best method of combining the costs of debt and equity to produce a weighted average cost of capital (WACC). There are, it seems, three possible candidates: (1) The weighted average of the cost of debt and of the before-tax cost of equity, w = & ( I -e j t Kie where K, = shareholders' required return before corporate taxes Ki = cost of debt B , g = -S t B S = market value of the equity B = market value of the debt.(2) The weighted average of the cost of debt and of the after-tax cost of equity,(3) The weighted average of the after-tax cost of equity and of the cost of debt as adjusted by the corporate tax rate, wdt = K,( 1 -6) t Ki( 1 -t)b
The Modigliani-Miller (MM) theorem that dividend policy is irrelevant to shareholder's wealth has been attacked by Gordon as being invalid under conditions of uncertainty. His argument rests on the proposition that investors are not indifferent between cash payments and increases in the market value of their shares, and that, with uncertainty, future dividends are discounted at a rate which increases with the distance in the future.Gordon represents the value of a share as [I] where PO = Share price Yo = Annual earnings and payout kt > kt-1The return required by shareholders=k, which is 'an average of the kt with Yo, the weight assigned to each item'. If the company retains YI = Yo and invests it to earn k Yo per period in perpetuity, equation (I) becomes + ...( 2) Po' = ~ 0 + Yo+kYo+ Yo+kYo+ Yo+kYo (1 +ki)l ( I +k2)2 (1 + A313 ( I + kt)t ...
...He concludes that 'the shareholder gives up Yo and gets KYo in perpetuity, but the latter is now discounted at the rates kt, t = 2 +-00 and it can be shown that k Yo, so discounted, is less than YO. Hence PO' c PO and dividend policy influences share price.'
This paper challenges the conventional share price maximizing objective and the assumption that a successful company can expect to achieve share price growth above the normal drift caused by inflation and earnings retention. The share price is an expectations-based measure, and more efficient companies have no greater prospect of outperforming market expectations than less efficient companies. The paper concludes that, given the potentially dysfunctional effects of pursuing a share price maximizing goal, it may be significant that share-price centred economies such as the UK and the US tend to be associated with a more short-termist perspective than bank-centred economies such as Germany and Japan.share price maximization, zero NPVs, short-termism,
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