Capital gains tax and the capital asset pricing model

Abstract

This paper develops a version of the Capital Asset Pricing Model that views dividend imputation as affecting company tax and assumes differential taxation of capital gains and ordinary income. These taxation issues aside, the model otherwise rests on the standard assumptions including full segmentation of national capital markets. It also treats dividend policy as exogenously determined. Estimates of the cost of equity based on this model are then compared with estimates based on the version of the CAPM typically applied in Australia, which differs only in assuming equality of the tax rates on capital gains and ordinary income. The differences between the estimates can be material. In particular, with a high dividend yield, allowance for differential taxation can result in an increase of two to three percentage points in the estimated cost of equity. The overall result obtained here carries over to a dividend equilibrium, in which firms choose a dividend policy that is optimal relative to the assumed tax structure. Copyright (c) AFAANZ, 2003.

Cost of capital equations under the Australian imputation tax system

“…setting T 1 and T 2 as (t i -t g )/(1 -t g ) = T (consistent with Lally and van Zijl, 2003), and rearranging, we have:…”

“…This is demonstrated with respect to the incorporation of personal tax effects into the CAPM. The paper shows that a simple CAPM encompasses several versions of the CAPM, including the traditional CAPM, Officer's (1994) CAPM, the Brennan-Lally CAPM (see Lally, 2000), and Lally and van Zijl's (2003) CAPM.…”

“…Notwithstanding a well-developed literature that addresses the impact of imputation (e.g. Cliffe and Marsden, 1992;Howard and Brown, 1992;Lally, 1992Lally, , 2002Lally, , 2004Monkhouse, 1993Monkhouse, , 1996Officer, 1994;Faff et al , 2000;Lally and van Zijl, 2003), the above questions remain open. Officer's (1994) version of the capital asset pricing model (CAPM) with associated weighted average cost of capital (WACC) valuation model has been the framework preferred by Australian regulators.…”

“…For example, the specification for the CAPM encompasses the Officer (1994) CAPM, the Brennan-Lally CAPM (see Lally, 2000), and Lally and van Zijl (2003) CAPM. The equations allow additionally for the impact of taxation on © The Authors Journal compilation © 2007 AFAANZ valuation depending on whether the project is funded externally or by retaining earnings.…”

Three essays on corporate finance modelling

“…In contrast to other tax related asset pricing models (Lally, 2000;Lally and van Zijl, 2003;Monkhouse, 1993;Stulz, 1981;Wood, 1997), we don't define explicit foreign investment barriers in our model. Rather, we operationalize the endowment and status quo biases using a regret based utility function.…”