Explanation:
CAPM is based on the assumption that assets are not subject to taxation (no taxes or transaction costs). However, when a tax such as a 25% capital gain tax is imposed on an asset, the actual net return realized by the investor is reduced by this friction. Consequently, the observed after-tax return of the stock will be less than the theoretical return predicted by the standard CAPM, which strictly assumes a frictionless, tax-free environment.
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Q.2387 Consider the graph presented below. The line represents the security market line derived from the Capital Asset Pricing Model (CAPM).
![Graph showing Return vs. Beta with points A, B, C, X, M, O, Y and risk-free rate Rf, with the Security Market Line (SML) plotted]
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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