Tax and the Use of Historic Returns in Estimating the Equity Risk Premium

Abstract

The paper analyses the use of a historic risk premium as a proxy for the current premium allowing current tax rates to differ from historic rates. If tax rates are assumed constant, adjustments to the CAPM for an imputation system make the CAPM and cash flows to be discounted consistently with respect to tax, but do not model any effect of tax on the cost of equity. If tax rates are allowed to vary and a historic premium is used, the cost of equity is affected by the level of tax at which investors are assumed to set their required premium. This is illustrated by considering the impact on the cost of equity of the change in the UK imputation system in July 1997.