I was reading this article from Stiglitz, a famous economist at Columbia, and this part of the article struck me as a bit odd:
"As Apple has shown, it can finance anything it wants to with debt – including paying dividends, another ploy to avoid paying their fair share of taxes. But interest payments are tax deductible – which means that to the extent that investment is debt-financed, the cost of capital and returns are both changed commensurately, with no adverse effect on investment. And with the low rate of taxation on capital gains, returns on equity are treated even more favorably."
http://www.guardian.co.uk/commentisfree/2013/may/27/globalisation-is-ab…
Maybe I'm missing something (haven't started FT training for IB yet) but is Stiglitz wrong to say that "to the extent that investment is debt-financed, the cost of capital and returns are both changed commensurately"? The way I understood it, interest is tax deductible so it does reduce your tax liability by a certain amount but this deduction shouldn't be enough to make a company indifferent between cash-financed and debt-financed investment, as it seems Stiglitz is claiming here.
Also, I wouldn't say that equity is treated more favorably than debt, given that the capital gains rate applies to both debt and equity and since debt has the extra advantage of tax deductible interest.
What am I missing here?
If you think of cash financing as retained earnings, and thus just equity (with the alternative being to reduce your equity via capital returns), this is just a comment on low cost of debt.
I simply read it as, taking on debt reduces the cost of capital and such increases returns.
The return on equity goes up when debt goes up. (To keep the same WACC, it's all theoretical - look up modigliani-miller and weighted average cost of capital).
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