Taxes, Leverage, and the Cost of Equity Capital

Posted: 17 Jan 2006

See all articles by Dan S. Dhaliwal

Dan S. Dhaliwal

University of Arizona - Department of Accounting (deceased)

Shane Heitzman

University of Southern California - Marshall School of Business

Oliver Zhen Li

National University of Singapore (NUS)

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Abstract

We examine the associations between 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. This expression predicts that the cost of equity is increasing in leverage, but 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 associated with leverage is increasing in the personal tax penalty associated with debt.

Keywords: Capital structure, Cost of capital, Tax

JEL Classification: G12, G32, H24, H25

Suggested Citation

Dhaliwal, Dan S. and Heitzman, Shane and Li, Oliver Zhen, Taxes, Leverage, and the Cost of Equity Capital. Journal of Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=875010

Dan S. Dhaliwal

University of Arizona - Department of Accounting (deceased)

Shane Heitzman

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd
Los Angeles, CA 90089
United States

Oliver Zhen Li (Contact Author)

National University of Singapore (NUS) ( email )

Bukit Timah Road 469 G
Singapore, 117591
Singapore

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