Company Valuation, Risk Sharing and the Governments Cost of Capital

Assuming a no arbitrage environment, this article analyses the role of the government in the context of company valuation when …rms follow di¤erent …nancial policies. For the two analyzed …nancial policies, the tax authority’s required returns and the value of tax payments are derived. Based on these results, we study the risk sharing e¤ects between equity owners and the government. It is shown that the government’s cost of capital is greater than (equals) the equity cost of capital for a …xed debt policy in a (no) growth setting. In contrast to the …xed debt case, the government’s cost of capital is smaller than the equity owner’s cost of capital in case of a no-growth constant leverage policy and usually smaller in the growth case. Most importantly, these results allow us to analyze the capital budgeting con‡icts between the government und equity owners. We show that …rms in some situations invest more than socially desirable. Moreover, the possibility of corporate overinvestment depends on the …nancial policy. Firms that follow a constant leverage policy never overinvest, but always underinvest. In contrast, …rms with …xed future levels of debt overinvest if the gain in tax-shields is big enough to outweigh the loss in the unlevered …rm value. Finally, our results illustrate that various policies available to the government to encourage investments to their socially optimal level should depend on the …nancing policy pursued by the …rm.