The Cost of Capital

Now, let us define the cost of capital by the marginal cost associated with the before-tax marginal return of capital, pFK. In other words, this cost shows how much return is needed in terms of the before-tax return. This break-even rate of return is called the cost of capital. If the cost of capital increases, a higher before-tax return is needed; thus, investment is depressed. Without taxes, the cost of capital is equal to the rental cost of capital and the market rate of interest. With taxes, the cost of capital may well be higher than the rental cost of capital. For example, if tax depresses the benefit of investment, the cost of capital rises and investment declines. The cost of capital is a useful indicator of the relation between investment and taxes.

With regard to bond finance, we still have pFK = r. The cost of capital is equal to r. With regard to retained earnings finance, the optimal condition is (1 — tI)pFK = r. Thus, the cost of capital becomes

which increases with tI. In other words, tax raises the cost of capital more than the rental cost of capital and the rate of interest.

 
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