After-tax Return from Securities of Companies X and Y
It is apparent from Table 3.7 that in spite of the lower expected return before taxes (14.5%) of company Y, its expected after-lax return is higher on account of the fact that a higher proportion of income/return consists of capital gains. Evidently, the tax-paying investor prefers securities of company Y to those of company X, in contrast, the tax-exempt investor will have a preference for’ company X, all other things being the same.
As a logical corollary of the above follows that high dividend paying securities may be required to provide higher expected returns before taxes the low dividend paying securities to offset the lax effect.
In view of the above, the CAPM equation for determining expected return is to be modified to include dividend yield and tax effect, as shown in Equation 3.32
K1 = R1 + bB1 + t(D1 – R1)
Where R,= Required rate of return on security, j
b = Coefficient showing the relative importance of beta
B, = Beta of security, j
t = Coefficient showing the relative importance of the tax effect.
D = Dividend yield on security, j .
It is apparent from equation 3.32 that the higher is the dividend yield, the higher is the expected before-tax return the: security may be expected to provide. In other words, if there is a with effect 200,5-4, dividend income from domestic Companies and mutual funds in India is exempt from tax in the hands of the shareholders and investor.