How Taxes on Firms Reduce the Risk of After-Tax Cash Flows

Abstract

Most firms make decisions based on one discount rate applied to expected net after tax cash flows. The need to adjust for differences in risk, other than leverage, is most often neglected. One source of risk differences is the tax system. Even for fully equity-financed firms there can be substantial effects of taxation on after-tax risk when there are depreciation deductions. Among the few studies of these effects, even fewer identify all effects correctly. Some claim to characterize the cost of capital, but fail to identify the marginal investment. When this is taxed together with inframarginal investment, marginal beta differs from average. To find asset betas, observed equity betas should not only be unlevered, but also “unaveraged” and “untaxed.” The problems identified here imply that currently suggested tax reforms may fail. Tax neutrality results rely on firms correctly discounting for risk, in particular the risk of tax deductions.

Keywords: Cost of capital, WACC, loss offset, tax shields, options

JEL Classification: F23, G31, H25