The effect of taxation on implied cost of equity capital in the UK - an analysis of real estate investment trusts

Abstract

Previous literature which has examined taxation and implied cost of equity capital has by necessity foucsed on tax paying firms. There are no studies which investigate what happens to the cost of equity capital when companies change their tax status. The introduciton of the Real Estate Investment Trusts (REITs) in the UK in 2007 provides such a setting. It allows estimation of implied cost of equity capital for UK REITs both pre and post conversion to examine the relationship between taxation an the cost of equity capital using a significant change in taxation.

This study will investigate whether the tax status of REITs has an effect on their implied cost of equity capital, and whether the existing models of implied cost of equity capital can be applied in the UK. These issues were empirically tested using implied cost of equity estimated by four different models.

The results suggest that the REITs exemption from corporation level tax is associated with a significant increase in their implied cost of equity capital for levered REITs after conversion date, the majority of the variables employed are consistent with the existing literature, and the implied cost equity estimation models have produced reasonable estimations concluding that these models are valid for UK firms.

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