ABSTRACT
A firm’s cost of capital is the rate of return which investors (or lenders) require in order to invest in it. Firms are not exclusively owned by shareholders. A firm’s value depends on its ability to transform some collection of resources into output, which when sold generates income. The inputs are acquired using the funds provided by equity and debt holders. Lenders are entitled to a predetermined fraction of the firm’s income. Once debt obligations are met, the government collects its (direct) share of firms’ profits. Shareholders own the residual claim to a portion of this stream of income. The crucial distinction between the claims of equity holders and debt holders
is not that interest payments are fixed and known in advance, while dividends are not. The payments on variable rate loans are neither fixed nor known in advance. The norm in the Mozambican credit market is for interest rates to be indexed to a money market rate. And dividends will be fixed if managers and shareholders decide that they should be so – if the firm has the cash to pay. The distinction is in the set of circumstances in which the providers of
capital can exercise control. For as long as an indebted firm can meet its obligations towards its lenders, equity holders control the firm. This assumes owner-managed firms, which is of course the dominant form of governance in Mozambique and most other developing countries. Once the firm fails to meet such obligations, however, control passes to lenders. When a firm approaches a financial intermediary to raise external finance, debt
and equity are alternative instruments through which the intermediary will gain access to some portion of the firms’ revenues. The regulations that govern Mozambique’s financial system recognize this by permitting banks to hold equity, as well as debt, in the corporate sector. But the tax system does not. It treats income from owning a priority claim to firms’ earnings (i.e. from lending) and income from residual claims (i.e. from owning equity) differently, by effectively taxing the latter more heavily (see GoM 2002a). This note seeks to explain clearly and precisely how, towhat extent andwithwhat implications for the cost of capital.
1.2 Double taxation of equity income and financial sector development
