Dividend Taxes and Implied Cost of Equity Capital

Abstract

We estimate firm level implied cost of equity capital based on recent advances in accounting and finance research and examine the effect of dividend taxes on the cost of equity capital. We investigate whether dividend taxes affect firms' cost of capital by testing the relation between the implied cost of equity capital and a measure of the tax-penalized portion of dividend yield, which we define as the product of yield and the dividend tax penalty. The results generally support the dividend tax capitalization hypothesis. We find a positive relation between the implied cost of equity capital and the tax-penalized portion of dividend yield that is decreasing in aggregate institutional ownership, our proxy for tax advantaged investors. We further explore the effect of institutional ownership on the dividend tax premium by partitioning institutional owners into groups of relatively homogeneous investors but fail to find consistent results across different institutions or different measures of cost of equity capital. This part of our analysis is exploratory, but we believe that it provides useful insights for future research that can identify stronger settings within which to examine the effects of investor tax attributes on the dividend tax premium.