Showing papers by "Oliver Zhen Li published in 2005"

Taxes, Leverage, and the Cost of Equity Capital

Abstract: We examine the associations between 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. This expression predicts that the cost of equity is increasing in leverage, but 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 associated with leverage is increasing in the personal tax penalty associated with debt.

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 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.

Shareholder Income Taxes and the Relation Between Earnings and Returns

Abstract: The purpose of this study is to investigate if and how shareholder level taxes affect earnings response coefficients (ERCs). Our tests indicate that when the tax rate on dividends increases, ERCs decrease for firms with high dividend yield and whose marginal investor is likely to be an individual. For firms with high share repurchase yield and whose marginal investor is likely to be an individual, an increase in dividend tax rate has no discernable effect on ERCs. These results are consistent with the notion that the tax penalty on dividends, relative to capital gains, reduces the earnings-return relation.

Taxes and Valuation: Evidence from Dividend Change Announcements

Abstract: I test whether and how shareholder income taxes affect the market response to dividend surprises. Under the US tax system, dividends are historically taxed at a higher rate than capital gains and thus receive a tax-related penalty. I provide evidence that the dividend tax penalty partially offsets the positive signaling and agency cost effects of dividends, and that the presence of tax advantaged institutional investors, proxied for by institutional ownership and the frequency of institutional trading, mitigates the negative dividend tax effect. My results support the notion that taxes impact valuation. I contribute to the literature by separating dividends' negative tax effect from their positive signaling and agency cost effects. My analysis also suggests that in event study settings, the frequency of institutional trading may be a more reliable proxy for investor tax attributes than institutional ownership.

Shareholder income taxes and the relation between earnings and returns

Abstract: The purpose of this study is to investigate whether and how shareholder-level taxes affect earnings response coefficients (ERCs). Our tests indicate that when the tax rate on dividends increases, ERCs decrease for firms with high levels of dividend yield and whose marginal investor is likely to be an individual. For firms with high levels of share repurchase yield and whose marginal investor is likely to be an individual, an increase in dividend tax rate has no discernible effect on ERCs. These results are consistent with the notion that the tax penalty on dividends, relative to capital gains, reduces the earnings-return relation.

Trading Clienteles, Tax Attributes, and Ex-Dividend Returns

Abstract: I examine whether institutions and individuals react to ex-dividend events and how their reactions impact ex-day excess return. I infer trader identities from trade size, based on the assumption that institutions initiate large trades while individuals initiate small trades. I find that while both increase their trading activities around the ex-days, institutions initiate more trades than individuals. Ex-day institutional and individual trading also impacts ex-day excess return, which decreases when excess trading volume by tax-favored institutions increases and increases when excess trading volume by tax-disfavored individuals increases. This result is consistent with differential taxation of dividends and capital gains influencing the ex-day pricing of dividends.

Heterogeneous Valuation of Accruals and Trading Volume

Abstract: This paper investigates the relation between trading volume and the magnitudes (ie, the absolute values) of accruals and operating cash flows around quarterly earnings announcement dates We hypothesize and find that trading volume at earnings announcements is positively related to the magnitude of accruals and is more positively related to the magnitude of accruals than to the magnitude of operating cash flows In addition, we find a positive relation between belief jumbling, a measure used in prior literature to proxy for investors' differential interpretations of earnings announcements, and the magnitude of accruals but not between belief jumbling and the magnitude of cash flows Our findings are consistent with the notion that accruals are an underlying source that contributes to investors' differential interpretations of earnings announcements, which, according to theory, stimulate trading volume

Institutional Investors, Financial Health and Equity Valuation

Abstract: This paper investigates the relation between institutional ownership, financial health, and the market valuation weights on earnings and book value of equity. We find that firms with high levels of institutional ownership are financially healthier, or less financially distressed, than firms with low levels of institutional ownership. More importantly, we find that the market valuation weight on earnings (book value of equity) increases (decreases) with the level of institutional ownership for profit firms. In contrast, the valuation weight on book value of equity increases with the level of institutional ownership for loss firms. Our findings of the above valuation effect of institutional ownership are consistent with two potential roles of institutions documented in prior literature: (1) institutions merely play a fiduciary role and (2) they play a positive governance role. Additional tests suggest that the level of institutional ownership appears to be an ex ante parsimonious proxy for both current and future financial health and that the valuation effect of institutional ownership cannot be subsumed by incorporating current measures of financial health. Moreover, we show that the valuation effect of institutional ownership is mainly driven by institutions with long investment horizons and monitoring incentives rather than institutions with short investment horizons and little monitoring incentives. We conclude that our findings of the valuation effect of institutional ownership are more consistent with institutions playing a positive governance role than merely playing a fiduciary role.