Does tax convexity matters for risk? A dynamic study of tax asymmetry and equity beta

Adrian C. H. LEI, Martin H. Y. YICK, Keith S. K. LAM

Research output: Journal PublicationsJournal Article (refereed)

3 Citations (Scopus)

Abstract

The purpose of this study is to explore the effect of tax convexity on firms’ market risk, where tax convexity measures the progressivity of firms’ tax function. We examine the relation between equity beta and tax convexity based on a standard contingent-claims model, in which firms face nonlinear tax schedules. We verify that in the presence of default and growth options, the effect of tax convexity on beta is significant and depends on several countervailing forces. Tax convexity has a direct, positive effect on beta, as well as two indirect countereffects through default and growth options. The overall effect is ambiguous and quantitatively significant. As asymmetric tax schedules are used in most countries, assuming a linear tax schedule in the valuation framework may misestimate beta and thus fail to assess risk accurately. Our theoretical model shows that tax convexity should be taken into consideration when estimating equity beta.
Original languageEnglish
Pages (from-to)131-147
Number of pages17
JournalReview of Quantitative Finance and Accounting
Volume41
Issue number1
Early online date21 Jul 2012
DOIs
Publication statusPublished - Jul 2013

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Bibliographical note

The authors acknowledge the financial support from the University of Macau.

Keywords

  • Equity beta
  • contingent-claim model
  • default option
  • growth option
  • tax convexity

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