RDP 9107: The Cost of Equity Capital in Australia: What can we Learn from International Equity Returns? 7. Discussion

(a) The IAPM

The analysis in Sections 5 and 6 has suggested that there may be more non-diversifiable risk in the Australian economy than in the typical foreign country. If the IAPM is valid, this implies that the required rates of return may be higher in Australia than in other countries.

This paper has not provided a formal test of the IAPM: such a test requires data for a large number of individual stocks across different countries. However, the assumption that the IAPM does hold across countries seems a reasonable starting point, as many studies of the cost of capital assume that the worldwide capital market is now well-integrated. A formal test of the IAPM is provided by Wood (1990, ch. 5), who uses Australian data to test whether the Australian market is segmented or integrated with the world market. His results do not provide clear support for either hypothesis: this may be a function of the high degree of noise in equity market data.

While Wood tests a one-factor model, the results of this paper suggest that a multi-factor model might be an interesting extension. In particular, Section 5 identifies metals prices and oil prices as having explanatory power for a number of countries. However, the existence of these covariances does not necessarily imply that a multi-factor model is the appropriate one. As Roll (1988, p. 543) points out: “Several factors may turn out to explain a larger proportion of intertemporal return volatility than a single factor, but this finding alone would not constitute evidence that a multiple-factor theory is better. That conclusion would also require an empirical finding that additional factors are indeed pervasive, non-diversifiable, and most important, that they are associated with additional risk premia.”

Therefore, to overturn the implication that high-beta countries will have higher required rates of return, there must be other non-diversifiable and priced factors that make those countries attractive to world investors. One possibility is that Australia's energy exposure may reduce its cost of equity. Individuals can hedge oil price risk by trading in energy stocks or futures: however, this risk will be fully diversifiable only if changes in oil prices have no effect on aggregate wealth. There is some evidence, though, that changes in oil prices do not simply represent a pure redistribution from consumers to producers, and that there are effects on the world economy. If so, further investigation of the premium on energy risk could be useful.

There may well be a number of reasons why the cost of equity might not differ across countries by as much as IAPM estimates might suggest. However, an offsetting factor that may boost the risk premium for Australia, is that if the IAPM or IAPT do not fully hold, residual, or non-market risk will become important. Table 4 does not report the level of unexplained variance for each country, but the regressions underlying those tables indicate that the unexplained variance of returns in Australia is higher than in other countries. If imperfect capital mobility means that investors in Australia do not undertake as much foreign investment as an arbitrage-based model would suggest,^[36] they will not have fully succeeded in diversifying this non-market risk away, as asset pricing models require. The equity premium in Australia will thus become dependent on the overall level of risk in Australian returns, and not just the world market component. And since there is apparently more unexplained variance in the Australian market, the equity premium in Australia might be higher than under the perfect capital-mobility assumption.^[37]

(b) The Effects of Taxation

The measures of risk and return used in this paper are generally made on an after corporate-tax but before personal-tax basis. These after corporate-tax returns were used to draw inferences about the risk premium on equity capital in Australia. The adjusted asset betas presented in Table 5 take account of the effects of corporate taxation and leverage on the risk premium, but no allowance is made for the effects of personal taxation. Also, the paper has not attempted to measure the effect of the corporate taxation system in driving a wedge between pre- and post-tax required rates of return.

The issue of the effect of personal tax rates is discussed by Miller (1977) who showed how personal tax rates would affect the willingness of lenders to invest in debt and equity, thus affecting the overall supply of debt and equity finance at the aggregate level. His analysis might suggest that an investigation of the cost of capital at a national level should proceed along the lines of King and Fullerton (1984): that is by looking at the particular tax arrangements for each type of personal income, and for each source of corporate finance.

However, a problem with some of these approaches is that the tax rates used are often the statutory marginal rates, which may bear little resemblance to actual rates paid by individuals. It has been argued for the United States, for example, that tax rates on dividends and capital gains are effectively zero.^[38] More generally, one should presume that companies will find ways to minimise the taxes that are paid both at the firm level and at the investor level. This suggests that tax rates on equity may effectively be quite low, and that even in classical tax systems, equity is not really taxed twice. It also suggests that any analysis based on personal statutory rates may place more importance than is warranted on tax factors.

An example of this is the argument that the introduction of dividend imputation significantly lowers the cost of equity in Australia. It is true that dividend imputation reduces the total tax paid on income that is distributed as dividends to eligible investors if they were previously paying tax. However, a number of points should be made. First, not all companies are able to pay fully franked dividends, nor are all investors (especially foreign investors) able to take full advantage of imputation. Second, imputation is a benefit already available (often to lesser extents) in a number of other countries, for example the UK, Canada, Germany, France, Italy, and now New Zealand.^[39] Third, the effect of imputation in Australia cannot be considered in isolation. The package of tax changes that introduced imputation made a number of other changes including the introduction of a real capital gains tax. That is, there was an offsetting change to the taxation of equity which by itself might have raised the cost of equity. One interpretation would be that dividend imputation has simply changed the incentives from paying out returns as capital gains which were untaxed at the personal level, to paying returns out as dividends which are now also only taxed once. As it turned out, Australian stock prices actually fell on the day that dividend imputation (and the rest of the tax package) was announced, so this interpretation may not be entirely incorrect.^[40] This lends support to the notion that analyses based on personal statutory rates may place more importance than is warranted on tax factors.^[41]

Footnotes

French and Poterba (1991) show that international investment is a far smaller proportion of total wealth than is implied by standard portfolio allocation models. [36]

In a closed economy model, the equity premium will presumably be determined, as in the consumption-oriented CAPM, by the overall level of consumption (or marginal utility) risk. Thus, McCauley and Zimmer (1989) use the volatility of real GNP growth as a proxy for earnings risk in various countries. However, in an open economy framework, the volatility of earnings will be less important than the way that those earnings covary with world earnings. [37]

See Hamada and Scholes (1985). [38]

See Borio (1990, p. 20) for imputation rates in some other countries. [39]

The tax package that included imputation was announced on 19 September 1985. The legislation was introduced on 2 April 1987, and imputation was implemented on 1 July 1987. Because parts of the initial announcement were known in advance, it may not be entirely appropriate to look only at the stock price movement on the day of the announcement. In addition, there may have been uncertainty as to whether or not imputation would actually be implemented. Nevertheless it is hard to ignore quotes from the Australian Financial Review like “Stockmarket dives ahead of tax package” (19/9/85, p. 1) and “It is very hard to think of stocks for which there will be a positive reassessment flowing from the tax reform” (23/9/85, p. 64). [40]

Alternatively, it may suggest that the cost of capital is simply not as important a factor as is often assumed. The stock price movement around the time of the tax reform announcement may have largely reflected other changes, such as those to fringe benefits taxation. Such factors affect the value of firms via cashflow calculations but do not affect discount rates. [41]