Fixed and Variable Tax Expense and the Cost of Equity Capital

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