Relationship between Franking Credits and the Market Risk Premium

24 Pages Posted: 18 Aug 2006

See all articles by Stephen Gray

Stephen Gray

University of Queensland - Business School; Duke University - Fuqua School of Business; Financial Research Network (FIRN)

Jason Hall

University of Michigan, Stephen M. Ross School of Business

Abstract

In a dividend imputation tax system, equity investors have three potential sources of return: dividends, capital gains and franking (tax) credits. However, the standard procedures for estimating the market risk premium (MRP) for use in the capital asset pricing model, ignore the value of franking credits. Officer (1994) notes that if franking credits do affect the corporate cost of capital, their value must be added to the standard estimates of MRP. In the present paper, we explicitly derive the relationship between the value of franking credits (gamma) and the MRP. We show that the standard parameter estimates that have been adopted in practice (especially by Australian regulators) violate this deterministic mathematical relationship. We also show how information on dividend yields and effective tax rates bounds the values that can be reasonably used for gamma and the MRP. We make recommendations for how estimates of the MRP should be adjusted to reflect the value of franking credits in an internally consistent manner.

Suggested Citation

Gray, Stephen and Hall, Jason L., Relationship between Franking Credits and the Market Risk Premium. Accounting and Finance, Vol. 46, No. 3, pp. 405-428, September 2006. Available at SSRN: https://ssrn.com/abstract=925311 or http://dx.doi.org/10.1111/j.1467-629X.2006.00175.x

Stephen Gray (Contact Author)

University of Queensland - Business School ( email )

University of Queensland
Brisbane, Queensland 4072
Australia

Duke University - Fuqua School of Business

Box 90120
Durham, NC 27708-0120
United States

Financial Research Network (FIRN) ( email )

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

Jason L. Hall

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street, Ross School of Business
University of Michigan
ANN ARBOR, MI MI 48104
United States
+1 734 926 6989 (Phone)

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
27
Abstract Views
917
PlumX Metrics