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Cost of capital equations under the Australian imputation tax system


  • We are particularly grateful to Stephen Gray, the referee, for his support of the paper along with valuable input. We acknowledge also the helpful comments of participants at the 2004 Conference of the Accounting and Finance Association of Australia and New Zealand, in particular Bruce Grundy; and also helpful comments of participants at Seminars at UNITEC, and at the Universities of Deakin, Melbourne and Macquarie. We thank Graham Bornholt, John Pierre Fenech, Alastair Marsden, Giang Truong, and Scott Walker for their help; and we thank the Capital Markets Co-operative Research Centre for its support.


Since the introduction of the Australian imputation tax system, there have been problems both in the measurement of the market value of franking (imputation tax) credits and in their application to estimating cash flows and the cost of capital. In the present paper, we provide a convenient and robust resolution to the above problems in the context of an internally consistent set of equations for the cost of capital, asset valuation and the capital asset pricing model (CAPM). The equations apply under both classical and imputation tax systems and under differential taxation of dividends, capital gains and interest. The simple form of the CAPM presented here is shown to encompass more complex versions of the CAPM, which attempt to accommodate the effect of personal taxes. The valuation equations require an estimate of the market value of $1 of the firm's dividends, within which is embedded the market value of the imputation tax credits. Separate estimates of the value of imputation tax credits, or Officer's gamma factor, are not required.