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Tax Avoidance and Ex Ante Cost of Capital

We investigate the relationship between tax avoidance and ex ante cost of capital. We provide evidence that investors perceive tax avoidance differently at different levels of tax avoidance. We find that, if low tax-avoidance firms increase tax avoidance, ex ante cost of capital declines. In contrast, if high tax-avoidance firms increase tax avoidance, ex ante cost of capital increases. These findings suggest a nonlinear, convex relationship between tax avoidance and ex ante cost of capital. We then estimate a firm-year-specific, expected level of tax avoidance for each sample observation and find that ex ante cost of capital increases as firms deviate from their expected levels of tax avoidance. On average, when firms deviate from their expected levels of tax avoidance in one year, they revert back toward their expected levels of tax avoidance in the following year.