Explain the effect of personal taxes on debt and equity rates of return.

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The Answer is In general,debt is less risky than equity,and thus requires a lower expected rate of return.To simplify this analysis,it is assumed that debt is risk-free with a promised coupon and return of r_D.It is also assumed that investors are risk neutral,so that the expected return on equity which more generally can be viewed as a pre-tax zero-beta expected return,differs from r_D only because of taxes.In the absence of taxes and other market frictions,the expected return of zero-beta equity equals the return on riskless debt.With personal taxes,however,it is necessary to account for the fact that the returns to equity,which often come in the form of capital gains,are generally taxed less heavily than the returns to debt.To compensate taxable investors for its relative tax disadvantage,the pre-tax return on debt should exceed the pre-tax zero-beta expected return on equity.This pre-tax return difference leads tax-exempt investors to prefer debt to equity.However,if the return difference is not too large,investors in the highest tax brackets should prefer equity to debt.There will also be investors who are indifferent between holding debt and equity.

Explain the Effect of Personal Taxes on Debt and Equity