Explanation:
CAPM is based on the assumption that assets are not subject to taxation. However, when tax is imposed on capital gains, a portion of the earnings is paid to the government. Consequently, the actual realized (after-tax) return observed by the investor will be less than the theoretical, pre-tax return predicted by the standard CAPM framework.
Q.2387 Consider the graph presented below. The line represents the security market line derived from the Capital Asset Pricing Model (CAPM).
[Image blocked: Graph showing Return vs. Beta with points A, B, C, X, M, O, Y and risk-free rate Rf, and the Security Market Line (SML)]
Stock X is subjected to a capital gain tax of 25%. What’s the most likely effect of taxes on stock X?
A
The observed return of the stock will be as predicted by CAPM.
B
The observed return of the stock will be more than that predicted by CAPM.
C
The observed return of the stock will be less than that predicted by CAPM.
D
None of the above.
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