How does a fi rms tax rate affect its cost of capital What is the effect of the flotation - Essay Example

17 July Question How does a firm’s tax rate affect its cost of capital? What is the effect of the flotation costs associated with a new security issue?Cost of capital refers to the rate of return which compensates investors for their investments in a venture. It helps compensate for the time value of money and the risk associated with the investment. A company may use several types of capital to finance its activities; these can be broadly divided into debt (loans) and equity (shares). Based on the proportion of funding from each source, an organization can calculate its “weighted average cost of capital”, i.e. the average cost of capital for the organization based on the percentage of funding obtained from each source.

The cost of capital can be calculated using valuation models such as CAPM or Arbitrage Pricing Model.Like all affairs of a business, the cost of capital is also affected by numerous factors, some within and some beyond the organization’s control. One of the factors which greatly affects the cost of capital and is beyond the control of the organization is the tax rate. Tax rate refers to the percentage of earning/spending which is contributed to the government. There are several types of taxes, applicable on different economic units, such as the income tax applicable on individuals, corporate tax applicable on corporations, sales tax applicable to sellers etc.

Of primary concern in an organization are the corporate tax rate and the capital gains tax. The corporate tax rate is used to calculate the cost of debt in the weighted average cost of capital. The higher the tax rate; the lower will be the cost of capital since the interest payments are tax deductible. The capital gains tax, on the other hand, is applicable to owners of capital in the organizations, i.e. the shareholders. An appreciation in the ownership of share prices requires the shareholders to pay a specific percentage (varies from country to country) to the government.

In such a case, the higher the capital gains tax, the lower will be the motivation of shareholders to hold their stocks. The tax rate structure applicable in a country determines the capital structure of a firm. If the corporate tax rate is higher than the capital gains tax rate then the structure will comprise of more debt and less shares and vice versa. In case an organization does not directly take a loan from a bank or financial institution, it may issue securities. Securities refer to any instruments (negotiable or non-negotiable) which allows an organization to raise funds, while floatation costs refer to the expenses incurred by the organization to issue new securities.

These include underwriters’ spreads, cost of marketing the security issue, legal costs and associated administration costs. The relationship between floatation costs and the cost of capital is positive; i.e. the higher the cost of issuing new security, the higher will be the cost of capital and hence a lesser contribution of share capital in the overall capital structure of the organization. In case a firm is issuing debentures or bonds, then too, the cost of debt will rise if the floatation costs are high resulting in a lesser contribution of securities in the capital structure.

Works CitedCoupon Mountain. “Floatation Cost” Investopedia. n.d. Web. 15 July 2011. Maestro. “Factors that Affect the Weighted Average Cost of Capital” Productivity at your daily life. 16 May 2009. Web. 13 July 2011 Pieterz, G. “Cost of Capital” Moneyterms.co.uk. 2005. Web. 13 July 2011.