If tax rates increase, what is the effect on each component of a firm’s cost of capital. Answer: Debt = decrease PS = No effect CE = No effect I understand how debt will decrease as Yield (1-T) For Common Equity however, when using the dividend discount model to get K, all else equal, if a firm pays higher taxes wont it’s retention ratio and therefore g be reduced lowering k ?
why do you believe a firm’s retention rate will be decreased due to an increase in taxes? the answer is decrease, no effect, no effect tax rate has no impact on the dividend payout rate, at least not within the scope of this course
If you use CAPM, a tax change has no effect on Common Equity…
The cost of debt is the aftertax cost of debt. At taxes going up, cost of debt decreases. It has no effect on the cost of equity because cost of equity is not tax deductible.