Fixed and Variable Tax Expense and the Cost of Equity Capital

44 Pages Posted: 8 May 2020

See all articles by Qintao Fan

Qintao Fan

University of Oregon, Lundquist School of Business

David A. Guenther

University of Oregon - Department of Accounting

Kaishu Wu

University of Waterloo

Date Written: April 13, 2020

Abstract

We incorporate fixed and variable costs into a cash flow based CAPM to investigate how each type of cost affects the cost of equity capital. A decrease in fixed costs always reduces cost of capital. With positive fixed costs, a decrease in the variable cost rate reduces cost of capital despite also increasing covariance risk. We then model income tax expense as containing both a fixed component (like a tax credit) and a variable component (a tax rate). Unlike other costs, the fixed tax component may be negative. Any decrease in the fixed tax component always reduces cost of capital. The effect of a decrease in the tax rate depends on the sign of the fixed tax component. With a negative fixed tax component, such as a tax credit, a decrease in the tax rate increases cost of capital. Results of empirical tests are generally consistent with our predictions.

Keywords: Cost of capital; tax avoidance; operating leverage; fixed and variable costs

JEL Classification: G12

Suggested Citation

Fan, Qintao and Guenther, David A. and Wu, Kaishu, Fixed and Variable Tax Expense and the Cost of Equity Capital (April 13, 2020). Available at SSRN: https://ssrn.com/abstract=3575256 or http://dx.doi.org/10.2139/ssrn.3575256

Qintao Fan

University of Oregon, Lundquist School of Business ( email )

Lillis Business Complex
#374
Eugene, OR 97403
United States
5143464865 (Phone)

David A. Guenther (Contact Author)

University of Oregon - Department of Accounting ( email )

Lundquist College of Business
1208 University of Oregon
Eugene, OR 97403
United States
541-346-5384 (Phone)

Kaishu Wu

University of Waterloo ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1 N2L 3G1
Canada

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