Personal Taxes & the CAPM

[deji]

Hi David,

I've been struggling today with the CAPM with the tax factor included. Specifically, I was confused about why the tax factor for the dividend yield of the stock is being added back to the return of the portfolio.

The only explanation I could come up with is that the beta of the risk premium less the tax on the dividend of the market portfolio somehow incorporates the tax on the dividend for the stock.

So the tax on the stock dividend is added back such that the expected return on the portfolio is a pre-tax return.

Can you pls confirm whether I'm right in my assumption? (I hope my question is clear)

Thanks very much,

Deji

 

[ShaktiRathore]

Hi there,
The CAPM required rate of return is the opportunity cost of holding the stock so that whatever return foregone by the investor by investing in stock is the minimum return the investor expects from the stock to derive any value. By holding the stock the investor is foregoing return in risk-less asset Rf, return from the market asset of similar risk and the tax that could have been saved by investing in the market instead of the stock so tax savings foregone are tax rate*(dividend yield on asset-dividend yield on market) i.e. extra taxes to be paid to invest in stock which should be included in required minimum rate of return so as to include entire costs of investing in the stock. So investor should expect minimum these returns to cover up the cost of investing in the stock including these extra tax paid on dividends. So we add up the tax on the stock dividend to get required minimum required rate of return as explained by capm that the investor should expect from investing in the stock based on the risk of the stock and its dividend yield.

thanks

 

[deji]

Thanks ShaktiRathore

 

[Backwardation]

By the way: Do you think that those "CAPM-assumption-deviation-models" such as the above mention tax-model will be very relevant for the exam?
I have never seen such a question in any practice exam or somewhere else. Or is this topic new in the 2013 exam?

Kind Regards,

 

[ShaktiRathore]

Backwardation hi,
ye there are such some deviation models from capm in curriculum which you should know. If not some day one Q might pop up relating to them in the exam. refer to foundations of risk topic Aims

thanks

 

[David Harper CFA FRM]

It's true the T1. Foundation AIMs devotes several AIMS to non-standard CAPM, but I've historically said they are "over-assigned" and, from a strictly exam-focused perspective ("what do i need to know to pass the exam?"), frankly this advise has been accurate. So far, it's a little like APT which was historically over-assigned, and finally, Elton Chapter 16 (APT) was dropped in the 2013 FRM.

Of course GARP could decide to test non standard CAPM in detail, but since everybody's issue is time, I still don't think Elton Chapter 14 deserves a "deep dive" at the expense of other topics. The most likely exam encounter (in my opinion) is a question (or two at the most) from Elton on theoretical non-standard CAPM. Meanwhile, using basic CAPM formula will almost certainly appear at least once. Please note the AIM verbs here are Describe not calculate ... not all AIMs are created equally:

• "Use the CAPM to calculate the expected return on an asset" is a more exam-important AIM than
• "Describe the impact on the CAPM of the following: Personal taxes"

 

[pradeep.uw]

thanks shakti rathore. good explanation.