Risk and Return in the Presence of Differential Taxation: Integrating the CAPM and Capital Structure Theory

Abstract

We consider risk-return and valuation in an economy segmented by the differential personal taxation of debt and equity assets. In equilibrium there exist two SMLs, one for debt securities and one for equity securities, which relate market (i.e., post-corporate tax, pre-personal tax) returns to asset risks. We characterize the conditions under which these two SMLs have the same price of risk (albeit, with different intercepts), and show the relation of this characterization to a generalized Miller equilibrium. We also characterize the conditions under which the standard value additivity conditions for a levered versus an unlevered firm hold (i.e., the tax effect of leverage is a linear function of the value of the debt). The results are derived in a framework consistent with capital market equilibrium with heterogeneous consumers and are not dependent on the functional form of the utility functions.

JEL Classification: G12, G32