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

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