Investment Appraisal, Taxes and the Security Market Line

Valuation and Cost of Capital Formulae with Corporate and Personal Taxes: A Synthesis Using the Dempsey Discounted Dividends Model

“…With the assumption that shareholders have equal tax liabilities on dividend income (t d ) and capital gains (t g ), Taggart (1991) and Strong and Appleyard (1992) provide identical expressions for the firm's overall cost of capital as a function of the unlevered cost (Taggart (3B.3), S&A (34)) and the firm's levered beta as a function of the unlevered beta (Taggart (3B.6), S&A (36)). With the assumption t d t g , we have q 1 in the present analysis (equation (3)).…”

“…A number of authors have presented formulations relating corporate financial performance to investors' returns at the afterpersonal tax level (notably in the context of the present paper, Taggart, 1991;Clubb andDoran 1991 andStrong and Appleyard, 1992;andDempsey, 1996 and1998). In these formulations, the price-setting function of the markets is modeled as a discounting process: expectations of corporate value are discounted into current asset prices.…”

Company Valuation: A Comparison of Economic and Legal Perspectives

“…The FCF is then discounted at the corporate post-tax weighted average cost of capital to give the value of the firm as a whole. Alternatively, and under some circumstances equivalently (Strong and Appleyard, 1992), the Myers (1974) adjusted present value approach can be used to estimate this value. From this, the value of debt claims is deducted and the value of non operating assets added to give the value of the issued equity.…”

“…The second problem is the estimation of an appropriate cost of capital. This problem encapsulates the choices of an appropriate returns generating model (for example, the capital asset pricing model (CAPM) or the arbitrage pricing theory (APT)), capital structure equilibrium model (see Strong and Appleyard [1992] for a discussion of the impact of the choice upon the WACC) and risk premium or premia, depending on the selected returns generating model. 3 Where asset net realisable values are higher than the present value of the FCF, the concept of opportunity values suggests that the value of the firm (and hence the equity) should be determined by the best obtainable break-up value.…”

“…Second, given that the 'size effect' leads to different costs of capital for small and large firms it is essential to consider the average sizes of the analogue companies being used to set the PER; the use of industry average PERs clearly fails to take account of this. A similar point applies to gearing levels; in a DCF model, analogue companies (variously termed 'proxy' or 'pure play' companies in the literature) can be used in an assumed capital structure equilibrium model to estimate the cost of capital of a company with gearing levels different from those of the analogue(s) of (Strong and Appleyard 1992). No such model exists to allow PERs to vary according to gearing levels 8 , meaning that an analogue company (or sector average company) must have the same gearing and size as the firm which is the subject of a PE based valuation.…”