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An analytical model of required returns to equity under taxation with imperfect loss offset

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Lund (2002a) showed in a CAPM-type model how tax depreciation schedules affect required expected returns after taxes. Even without leverage higher tax rates implied lower betas when tax deductions were risk free. Here they are risky, and marginal investment is taxed together with inframarginal in an analytical model of decreasing returns. With imperfect loss offset tax claims are analogous to call options. The beta of equity is still decreasing in the tax rate, but increasing in the underlying volatility. The results are important if market data are used to infer required expected returns, and in discussions of tax design.

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File URL: http://www.sv.uio.no/econ/english/research/unpublished-works/working-papers/pdf-files/2005/Memo-13-2005.pdf
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Paper provided by Oslo University, Department of Economics in its series Memorandum with number 13/2005.

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Length: 42 pages
Date of creation: 15 May 2005
Publication status: Published as Lund, Diderik, 'How taxes on firms reduce the risk of after-tax cash flows' in FinanzArchiv/Public Finance Analysis, 2014, pages 567-598.
Handle: RePEc:hhs:osloec:2005_013
Contact details of provider: Postal:
Department of Economics, University of Oslo, P.O Box 1095 Blindern, N-0317 Oslo, Norway

Phone: 22 85 51 27
Fax: 22 85 50 35
Web page: http://www.oekonomi.uio.no/indexe.html
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  1. Green, Richard C & Talmor, Eli, 1985. " The Structure and Incentive Effects of Corporate Tax Liabilities," Journal of Finance, American Finance Association, vol. 40(4), pages 1095-1114, September.
  2. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
  3. Jeremy I. Bulow & Lawrence H. Summers, 1982. "The Taxation of Risky Assets," NBER Working Papers 0897, National Bureau of Economic Research, Inc.
  4. Diderik Lund, 2002. "Taxation, Uncertainty, and the Cost of Equity," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 9(4), pages 483-503, August.
  5. Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, Oxford University Press, vol. 101(4), pages 707-727.
  6. Shanker, Latha, 2000. "An innovative analysis of taxes and corporate hedging," Journal of Multinational Financial Management, Elsevier, vol. 10(3-4), pages 237-255, December.
  7. Fane, G., 1987. "Neutral taxation under uncertainty," Journal of Public Economics, Elsevier, vol. 33(1), pages 95-105, June.
  8. McDonald, Robert & Siegel, Daniel, 1984. " Option Pricing When the Underlying Asset Earns a Below-Equilibrium Rate of Return: A Note," Journal of Finance, American Finance Association, vol. 39(1), pages 261-265, March.
  9. Steve Bond & Michael Devereux, 1993. "On the design of a neutral business tax under uncertainty," IFS Working Papers W93/01, Institute for Fiscal Studies.
  10. Diderik Lund, 2003. "How to analyze the investment–uncertainty relationship in real option models?," EPRU Working Paper Series 03-17, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics.
  11. Lund,D., 2001. "Taxation, uncertainty, and the cost of equity for a multinational firm," Memorandum 13/2001, Oslo University, Department of Economics.
  12. Levy, Haim & Arditti, Fred D, 1973. "Valuation, Leverage, and the Cost of Capital in the Case of Depreciable Assets," Journal of Finance, American Finance Association, vol. 28(3), pages 687-693, June.
  13. Diderik Lund, 2002. "Petroleum Tax Reform Proposals in Norway and Denmark," The Energy Journal, International Association for Energy Economics, vol. 0(Number 4), pages 37-56.
  14. Ray Ball & John Bowers, 1983. "Distortions Created by Taxes Which are Options on Value Creation: The Australian Resources Rent Tax Proposal," Australian Journal of Management, Australian School of Business, vol. 8(2), pages 1-14, December.
  15. Gordon A. Sick, 1990. "Tax-Adjusted Discount Rates," Management Science, INFORMS, vol. 36(12), pages 1432-1450, December.
  16. Benninga, Simon & Sarig, Oded, 2003. "Risk, returns, and values in the presence of differential taxation," Journal of Banking & Finance, Elsevier, vol. 27(6), pages 1123-1138, June.
  17. Hall, Robert E & Jorgenson, Dale W, 1969. "Tax Policy and Investment Behavior: Reply and Further Results," American Economic Review, American Economic Association, vol. 59(3), pages 388-401, June.
  18. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, 09.
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