Tax-Loss Carry Forwards and Firms' Risk

Abstract

Tax loss carryforwards (TLCF) --- accumulated losses that reduce taxable income --- are an important and risky corporate asset. We show theoretically how TLCF affect equity risk: If TLCF are low and will be used with certainty, equity risk is decreasing with TLCF because TLCF represent a safe cash flow; if TLCF are high, equity risk is increasing in TLCF because TLCF are likely to expire unused when cash flow is low. In a calibrated model the latter effect dominates and risk is increasing in TLCF on average. Empirically, TLCF positively forecast firms’ volatility, beta, return, and cost of capital.

Keywords: Tax-Loss Carry Forward, Risk, Equity Returns

JEL Classification: G10, G12, G30, G32