Brattle Principal Bin Zhou and Boston University Professor Dirk Hackbarth recently co-authored an article published in Tax Notes about how the Tax Cuts and Jobs Act (TCJA) will affect a company’s capiVtal structure and the after-tax weighted average cost of capital (COC).

The article, “Effects of New Tax Law on Capital Structure and Cost of Capital,” acknowledges that the TCJA introduces fundamental changes the U.S. tax system, which could affect a company’s investment and financing decisions, and its cost of debt and equity capital. Because it will take time for the full impacts to become observable, this article discusses analytical and economic determinants of leverage ratios and funding costs to predict the new law’s tax implications.

The authors point out that the TCJA’s immediate and most straightforward effect is a modest increase of the after-tax cost of debt, hence COC. However, they caution against additional downward adjustment to the company’s use of debt, which could further increase COC. They present both empirical evidence and theoretical arguments to show, perhaps surprisingly, the TCJA is unlikely to lead to lower leverage ratios in the near future.

Overall, the authors therefore predict that the TCJA’s ultimate effect will be largely limited to a COC increase by the after-tax cost of debt. The cost of capital increase will attenuate slightly the primary impact of the TCJA on higher after-tax cash flows and hence higher valuations, as reflected in the stock market rally at the end of 2017 and announcements by many large corporations to increase stock buybacks, repatriate foreign earnings, etc.

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Effects of New Tax Law on Capital Structure and Cost of Capital