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The Relative Cost of Internal vs. External Equity in South Africa: The Impact of Capital Gains and Dividend Taxes

Abstract In order to investigate the impact of South Africa’s unique historical secondary tax on companies (STC) on optimal capital structure, we adapt the US methodology developed by Lewellen and Lewellen (2006) to cater for STC. Using our derived STC-models, we examine the combined effect of South Africa’s capital gains tax and, respectively, its historical and current dividend tax regimes, on the relative costs of internal and external equity, and thus the theoretical optimal South African capital structure both historically and currently. We examine the expected position of each of these areas in light of South Africa’s transition from STC to the new shareholder dividend tax (SDT) regime that replaced it on 1 April 2012. We conclude that there is a net tax benefit to utilising internal equity under certain conditions and that firm financing and payout decisions that ignore this benefit are fundamentally incomplete.