Corporate Tax, Cost of Debt, Cost of Equity and Capital Structure: a Case Study of Reits and Conventional Real Estate Firms in the Uk

Topics: Corporate finance, Modigliani-Miller theorem, Cost of capital Pages: 27 (8377 words) Published: May 23, 2013
Corporate Tax, Cost of Debt, Cost of Equity and Capital Structure: A case study of REITs and conventional real estate firms in the UK

University of Groningen
Faculty of Economics and Business

BSc International Business

January 2013

Table of contents

1. Introduction4
2. REITs7
3. Literature Review9
3.1 Capital Structure Irrelevance9
3.2 Present Models10
4. Data and Methodology12
4.1 Regression12
5. Findings and Discussion16
6. Conclusion20
7. Appendix21
8. Bibliography30


In January 2007 the UK adopted the globally successful real estate investment trust (REIT) regime, allowing real estate firms to adopt the REIT status with the benefit of immediate exemption from corporate tax. This study observes 14 UK REITs and 18 comparable conventional UK real estate firms during the years 2001-2011 to scrutinize in how far the corporate tax exemption affects cost of debt and equity and eventually capital structure itself. I employ a difference-in-differences (DiD) analysis, whereby I contrast changes in several variables of REITs and Non-REITs in the pre- and post-treatment phase. This setup enables me to establish empirical results of the given relationship in the absence of changes in exogenous determinants. I find that the cost of debt of REITs rises by just above 30 percent compared to that of Non-REITs. Moreover, the results show that whereas REITs financed a 21 percent increase in total assets with an almost 50/50 debt to equity ratio, Non-REITs financed a 41 percent increase in total assets with 70/30 debt to equity. This confirms the expectation that REITs use relatively less debt because of the missing tax incentive and higher implied costs of debt. However, I do not obtain significant results from the DiD analysis, that this is caused by this treatment.

Key words: REITs, corporate tax exemption, security issuance decision Research theme: Cost of debt, cost of equity and capital structure Supervisor: Dr. Henk von Eije

1. Introduction

Capital structure theory plays a decisive role in the corporate and financial world, and although it has been subject to a great amount of academic research, the relationship of cost of capital and capital structure remains an unsolved puzzle for financial economists (Howe, Shilling (1988), Maris, Elayan (1990)). Furthermore, most of the existing research results in abstract theories and concepts with empirical proof lagging behind the theoretical research, as the included variables are often difficult to isolate and to observe. (Titman and Wessels, 1988)

This study aims to shed light on the impact of the exemption of corporate tax on the cost of debt relative to the cost of equity and eventually on capital structure by analyzing and comparing REITs to conventional real estate firms. REITs are chosen as the center of this study, as they allow a type of natural experiment. The essential aspect to this set-up is that once conventional real estate firms start to function under the REIT regime, they become tax-exempt, which is expected to cause a sudden increase of their cost of debt component due to the now missing tax shield, previously imposed by the debt. This is derived from the calculation for the weighted cost of capital (WACC). That is the sum of the cost of equity (Re) multiplied with total equity (E) over total assets (A) plus the cost of debt (Rd) multiplied with one minus the corporate tax rate (T) and the ratio total debt (D) over total assets. This study aims to examine whether and by how much the cost of debt and equity change after tax exemption and if so how this affects in turn the capital structure of a firm.

This leads to the following research questions:
1. Does tax exemption affect the cost of debt and equity and if so, by how much? 2. Does the capital structure change due to a rise in the cost of debt relative to the cost of equity?

As I elaborate in the literature review, I...

Bibliography: Ambrose, B., Highfield, M. J., & Linneman, P. D. (2005). Real Estate and Economies of Scale: The Case of REITs. Real Estate Economics, 33(2), 323-350.
Brown, D
Baker, M. & Wurgler, J. (2002). Market Timing and Capital Structure. Journal of Finance, 57(1), 1-32.
Card, D. & Krueger, A. B. (1994). Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania. American Economic Review, 84(4), 772-793.
Deloitte. (2012). UK REITs: A Summary of the Regime. Retrieved from
Dhaliwal, D., Heitzman, S., & Li, O
Howe, J.S., & Shilling, J.D. (1988). Capital Structure Theory and REIT Security Offerings. Journal of Finance, 43(4), 983-93.
Howton, S., Howton, S., & McWilliams, V
Jensen, M. C. & Meckling, W. H. (1976). Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics, 3(4), 305-60.
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London Stock Exchange
Maris, B., & Elayan, F. (1990). Capital Structure and the Cost of Capital for Untaxed Firms: The Case of REITs. AREURA Journal, 18(1), 22-39.
Miglo, A. (2010). The Pecking Order, Trade-Off, Signaling, and Market-Timing Theories of Capital Structure: A Review. Available at SSRN: or
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Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48(3), 261-97.
Myers, S
Titman, S. & Wessels, R. (1988). The Determinants of Capital Structure Choice. Journal of Finance, 43(1), 1-19.
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