Taxes, leverage, and the cost of equity capital

Dan Dhaliwal, Shane Heitzman, Oliver Zhen Li

Research output: Contribution to journalArticlepeer-review

137 Scopus citations

Abstract

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.

Original languageEnglish (US)
Pages (from-to)691-723
Number of pages33
JournalJournal of Accounting Research
Volume44
Issue number4
DOIs
StatePublished - Sep 2006

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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