Optimal Tax Risk and Firm Value

I use the tax reserve data available from FIN 48 to investigate whether equity market value and tax risk exhibit a concave association, consistent with an optimal level of tax risk from an equity valuation standpoint. I find a concave association between tax risk and firm value which suggests firm value is increasing in tax risk at a diminishing rate until an optimal level is reached, after which firm value is decreasing in tax risk. I do not find evidence of excessive risk taking in the context of tax avoidance. Instead almost all firms in my sample are below the average implied optimal level of tax risk. Tax risk impacts firm value not only through its effect on expectations about future cash flows but also through its effect on the cost of equity capital. I also document a higher average optimal level of tax risk for firms where the CEO is not the chairman of the board, consistent with an agency view of tax avoidance. I find that institutional ownership levels moderate the association between tax risk and firm value but the average optimal level of tax risk does not vary with institutional ownership.