Dividend Taxes and Implied Cost of Equity Capital

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 dividend 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. The evidence in this study adds to the understanding of the effect of investor-level taxes on equity value. Copyright 2005 The Institute of Professional Accounting, University of Chicago.