Abstract
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.
Keywords: Corporate tax, depreciation, imperfect loss offset, decreasing returns,
cost of capital, uncertainty
Levy and Arditti (1973) introduced depreciable assets into the Modigliani and
Miller (1958) model, and analyzed the implications for the cost of capital. Assuming
that the firm reinvests indefinitely to maintain a constant expected cash flow, they
found that depreciation increases the cost of capital before and after tax. Most of
their assumptions are maintained. However, commitment to perpetual reinvestment
is in most cases not a reasonable assumption. Without it, depreciation decreases the
cost of capital before and after tax. The effect of depreciation is less in absolute value
than in Levy and Arditti, but not insignificant.
Keywords: Cost of capital, depreciation, corporate taxes
JEL classification numbers: G31, H25