Taxes, Leverage, and the Cost of Equity Capital

Dan S. Dhaliwal · Shane M. Heitzman · Oliver Zhen Li

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Corporate Finance and Governance Corporate Taxation and Avoidance Financial Reporting and Valuation Research

Abstract

We examine the associations between leverage, corporate and investor level taxes, and the firm's implied cost of equity capital. Expanding on Modigliani and Miller [1958,1963], the cost of equity capital can be expressed as a function of leverage and corporate and investor level taxes. This expression predicts that the cost of equity is increasing in leverage, but that corporate taxes mitigate this leverage related risk premium, while the personal tax disadvantage of debt increases this premium. We empirically test these predictions using implied cost of equity estimates and proxies for the firm's corporate tax rate and the personal tax disadvantage of debt. Our results suggest that the equity risk premium associated with leverage is decreasing in the corporate tax benefit from debt. We find some evidence that the equity risk premium associated with leverage is increasing in the personal tax penalty associated with debt.

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References

1993Common risk factors in the returns on stocks and bonds 1968FINANCIAL RATIOS, DISCRIMINANT ANALYSIS AND THE PREDICTION OF CORPORATE BANKRUPTCY 1958The Cost of Capital, Corporation Finance and the Theory of Investment 1973Risk, Return, and Equilibrium: Empirical Tests 2008The cost of capital, corporation finance and the theory of investment 1961Dividend Policy, Growth, and the Valuation of Shares 1963CORPORATE INCOME TAXES AND THE COST OF CAPITAL: A CORRECTION 1995Earnings, Book Values, and Dividends in Equity Valuation*

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