Aggressive tax avoidance policies can increase corporate cash flows (and shareholder value) but invite greater uncertainty and possible future costs to the firm. Current accounting authorities have attempted to use such strategies as proxies to capture a firm’s overall tax risk. A new research paper, “Tax Risk and the Cost of Equity Capital,” evaluates the extent to which these recently developed proxies accurately measure the firms' risk, as reflected in the cost of capital. After conducting their study, authors Michelle Hutchens and Sonja Rego (both from Indiana University) find:

The level of a firm’s reserve for income taxes is significantly positively associated with the cost of equity capital, consistent with tax reserves capturing uncertainty surrounding a firm’s tax positions, i.e., tax risk. However, we also find that several other proxies for aggressive tax avoidance are not associated with the cost of capital, while lower cash effective tax rates are associated with lower costs of capital. We conclude that these tax avoidance metrics do not capture uncertainty surrounding a firm’s future after-tax cash flows and, therefore, do not capture a firm’s exposure to tax risk.

A second paper takes a look at the “routine steps” of levering/unlevering beta in various cost of capital models that valuation analysts commonly use in the income approach. In “The Pitfalls of Levering and Unlevering Beta and Cost of Capital Estimates in DCF Valuations,” authors Robert Holthausen (University of Pennsylvania) and Mark Zmijewski (University of Chicago) examine current research and conclude:

The levering and unlevering formulas that are most commonly used in practice are not appropriate for valuing many companies. They also illustrate the shortcomings of—and substantial valuation errors that can result from—the common practices of assuming that the betas of securities like debt and preferred stock are equal to zero and ignoring the effects of equity-linked securities such as employee stock options, warrants, and convertible debt.

The article appears in the current issue of the Journal of Applied Corporate Finance(available by subscription only). Notably, the authors have published a second article in the same issue: “Valuation With Market Multiples: How to Avoid Pitfalls When Identifying and Using Comparable Companies.”