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

37 Pages Posted: 21 Feb 1998

See all articles by Oded Sarig

Oded Sarig

Interdisciplinary Center (IDC) Herzliyah - Adelson School of Entrepreneuship; University of Pennsylvania - The Wharton School

Simon Benninga

Tel Aviv University - Faculty of Management

Date Written: January 1998

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

Suggested Citation

Sarig, Oded H. and Benninga, Simon, Risk and Return in the Presence of Differential Taxation: Integrating the CAPM and Capital Structure Theory (January 1998). Available at SSRN: https://ssrn.com/abstract=61288 or http://dx.doi.org/10.2139/ssrn.61288

Oded H. Sarig (Contact Author)

Interdisciplinary Center (IDC) Herzliyah - Adelson School of Entrepreneuship ( email )

P.O. Box 167
Herzliya, 46150
Israel

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Simon Benninga

Tel Aviv University - Faculty of Management ( email )

P.O. Box 39010
Ramat Aviv, Tel Aviv, 69978
Israel
+972-3-640-6317 (Phone)
+972-2-673-4675 (Fax)

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