Assume that the user cost of capital (C) is simply
where r is the after tax rate of return, ? is the depreciation rate, ? is the corporate tax rate and,
r is the individual tax rate. Now assume further that the after-tax rate of return is 10 percent
and the economic depreciation rate is 2 percent. The firm faces corporate taxes of 35 percent
with an individual tax rate of 25 percent. Suppose that we now know that the present value of
depreciation allowances is 0.20. In addition, there is an investment tax credit of 0.10. What
effect does this new information have on the user cost of capital?
Solving for C yields C = (0.10 + 0.02)/(1 - 0.35)(1 - 0.25) = 0.2462 or 24.62%. Then multiply it
by (1 - 0.20 - 0.10). In the presence of depreciation allowance and investment tax credit, the
cost of capital can be calculated as:
where ? is the depreciation allowance and k is the investment tax credit. Therefore, we have
0.2462(1 - 0.20 - 0.10) = 0.1723 or 17.23%. The user cost of capital is now lowered.
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