Costs Could Rise

The article “ Tax Relief—Chapter 2003 ” ( JofA , Oct.03, page 41) doesn’t mention the unfavorable impact that reducing dividend taxes is likely to have on corporate America’s overall risk-adjusted cost of funds (that is, the weighted average cost of capital). The cost of capital for many companies will increase for the following reasons:
First, since the cost of equity capital is typically several points higher than the cost of debt, increased returns to equity (higher aftertax dividends) will cause a greater portion of capital funding to shift to equity and thus raise the overall weighted average cost of capital.

Second, although increased returns to equity will reduce the cost of equity capital, nothing happens in the capital markets in isolation. If returns to equity increase, returns to debt also will have to increase to remain competitive, all other things remaining equal. Corporate borrowing costs will jump and this will negatively affect earnings, thus somewhat offsetting the decrease in the cost of equity caused by reduced taxes.

In summary, a higher cost of debt and a greater percentage of equity financing will likely more than offset a net decrease in the cost of equity and thus result in a higher weighted average cost of capital for corporate America.

Why is a higher cost of capital unfavorable? Most companies require investment projects to generate returns that meet or exceed the cost of capital rate. The higher the cost of capital, the fewer the projects that will be approved, thus causing a further slowdown in capital spending, one of the major problems of our current sluggish economy.

Paul M. Green, CPA
Cincinnati