THE COST OF CAPITAL AND ITS COMPONENT PARTS WITH CORPORATE AND PERSONAL TAX

The purpose of this paper is to calculate the cost of capital, the cos t of equity and the cost of debt in a world with corporate and persona l taxes. We do this in a manner that is consistent with the calculatio n when there is no tax and when there is corporate tax only. Our resul ts differ from most finance textbooks which either ignore the calculat ion or assume that the entire burden of personal tax is borne by the s tockholders regardless of the level of tax on debt income. Specificall y, in these texts the market value of debt remains constant and hence the decline in the value of the firm due to the imposition of personal tax on debt is paid by a matching reduction in shareholders equity. I n addition, the approach in these texts can lead to a negative value o f the firm and a decreasing cost of capital even when the personal tax on debt income exceeds the personal tax on stock income.