We thank workshop participants at Purdue University, Northwestern University, Stanford University, and the University of Washington as well as George Foster, David Larcker, and an anonymous referee for helpful comments and suggestions. We thank John Graham for providing the simulated tax rates used in this study and I/B/E/S for providing analyst forecast data.
Taxes, Leverage, and the Cost of Equity Capital
Article first published online: 20 JUN 2006
Journal of Accounting Research
Volume 44, Issue 4, pages 691–723, September 2006
How to Cite
DHALIWAL, D., HEITZMAN, S. and ZHEN LI, O. (2006), Taxes, Leverage, and the Cost of Equity Capital. Journal of Accounting Research, 44: 691–723. doi: 10.1111/j.1475-679X.2006.00214.x
- Issue published online: 20 JUN 2006
- Article first published online: 20 JUN 2006
- Received 25 February 2005; accepted 10 January 2006
We examine the associations among 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. Based on this expression, we predict that the cost of equity is increasing in leverage, and 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 from leverage is increasing in the personal tax penalty associated with debt.