Do German Firms Earn the Cost of Capital Considering Tax Effects caused by Debt and Provisions?

In this paper the performance of a sample of German companies is measured by comparing the initially invested capital adjusted for cost of capital, dividends paid, share repurchases and equity raised with the market value at the end of the holding period. All possible holding periods between 1987 and 2000 are covered. The sample is subdivided into companies listed in the DAX-, MDAXand SMAX-index. Performance is measured based upon the actual capital structure (levered performance) and also after assuming the company is financed by equity only (unlevered performance). It can be shown that tax shields on debt and provisions contribute considerably to levered performance. This applies especially to the subsample of DAX companies. These tax effects can turn value decreasing holding periods into value increasing holding periods. If the tax disadvantage on bond income as in Miller (1977) is considered, tax effects of debt financing are close to zero or are even negative depending upon the level of tax free capital gains assumed. Tax shields on provisions exceed tax shields on debt quite regularly.