Scandinavian Working Papers in Economics

Working Papers,
Copenhagen Business School, Department of Economics

No 03-2003: Valuation, leverage and the cost of capital in the case of depreciable assets

Diderik Lund
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Diderik Lund: Department of Economics, Copenhagen Business School, Postal: Department of Economics, Copenhagen Business School, Solbjerg Plads 3 C, 5. sal, DK-2000 Frederiksberg, Denmark

Abstract: Levy and Arditti (1973) introduced depreciable assets into the Modigliani and Miller (1958) model, and analyzed the implications for the cost of capital. Assuming that the firm reinvests indefinitely to maintain a constant expected cash flow, they found that depreciation increases the cost of capital before and after tax. Most of their assumptions are maintained. However, commitment to perpetual reinvestment is in most cases not a reasonable assumption. Without it, depreciation decreases the cost of capital before and after tax. The effect of depreciation is less in absolute value than in Levy and Arditti, but not insignificant.

Keywords: Cost of capital; depreciation; corporate taxes

JEL-codes: G31; H25

22 pages, August 22, 2006

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