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Taxes, Leverage, and the Cost of Equity Capital
Author(s) -
DHALIWAL DAN,
HEITZMAN SHANE,
ZHEN LI OLIVER
Publication year - 2006
Publication title -
journal of accounting research
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 6.767
H-Index - 141
eISSN - 1475-679X
pISSN - 0021-8456
DOI - 10.1111/j.1475-679x.2006.00214.x
Subject(s) - cost of capital , cost of equity , debt to capital ratio , equity capital markets , monetary economics , equity risk , leverage (statistics) , business , capital structure , corporate tax , weighted average cost of capital , economics , debt , financial economics , equity ratio , tax avoidance , finance , double taxation , microeconomics , financial capital , private equity , profit (economics) , capital formation , machine learning , computer science
We examine the associations among 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. Based on this expression, we predict that the cost of equity is increasing in leverage, and 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 from leverage is increasing in the personal tax penalty associated with debt.