Using a cross-sectional regression methodology, the authors measure how the
taxation of dividends and debt affects firm value. The authors find that firm
value is positively related to dividends and negatively related to debt, which
refutes many of the existing tax hypotheses concerning firm financing decisions.
The authors infer that dividends and debt convey information about profitability
that dominates any tax effects of financing decisions.
The authors use cross-sectional regressions of firm value on earnings, investment, and
financing variables to measure tax effects in the pricing of dividends and debt. The
market value of a firm is the sum of two components: (1) the market value of an all
equity, no-dividend firm with the same pretax expected net cash flow as the firm and (2)
the value of the tax effects of the firm's expected dividend and interest payments. The
authors argue that if control variables can capture information about pretax expected
net cash flows in financing decisions, then estimated regression coefficients on
dividend and debt variables can isolate tax effects.
Using a wide range of variables to proxy for pretax expected net cash flows, the authors
fail to find reliable evidence of tax effects. The estimated marginal relationship
between firm value and dividends is positive, and the estimated marginal relationship
between leverage and value is typically negative. Many of the existing tax hypotheses
suggest a positive relationship between debt usage and firm value.
Although the authors' results fail to measure the tax effects of financing decisions,
they do provide information about value created by investment and financing decisions.
Furthermore, evidence presented by the authors contradicts the results of published
event studies and provides more-robust information concerning the relationship between
dividends and value. Event study evidence suggests that the univariate response of stock
prices to investment announcements is weak, but in their cross-sectional regressions,
the authors find a strongly positive relationship. Event studies show that changes in
dividends produce stock price changes of the same sign; the authors' results are more
robust in that they indicate that dividends have information about value that is missed
by earnings, investment, research and development, and debt. Any negative tax
consequences for the pricing of derivatives are obscured by the positive information
implications.
Finally, although event studies find that the response of stock prices to changes in debt
is small and statistically unreliable, the authors find a negative relationship between
debt and value even after controlling for earnings, dividends, investment, and research
and development.