market risk premium_2008

8/4/2019 Market Risk Premium_2008

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Market Risk Premium

A Review Paper

Professor Bob Offic er and Dr Steven Bishop

Prepared for Energy Networks Association, Australian Pipeline

Industry Assoc iat ion and Grid Australia

August 2008

Leve l 40, 140 William StMelbourne Vic 3000

Contact: [email protected] 195 177


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Conclusion.

The averag e historica l ma rket risk p rem ium i.e. the ob served ma rket rate of return less theyield on Government bonds, is estimated as 6.7% over the period 1958 to 2007 if there is novalue p laced on a return to investors for imp utation ta x benefits1.

A market risk premium of 6% has been widely used in regulatory price determinations inAustralia. We have reviewed a nd upda ted the historical emp irical evide nce and w ehaveexamined the argument for change in the MRP in light of forward looking as well ashistorical evidenc e. We a re o f the view that there is no p ersuasive e vide nce to red uce thisma rket risk p rem ium but there is some persuasive a rgum ent to increase it to 7%.

The best source of a forwa rd looking market risk premium is, in our view , a long te rmaverag e o f histo rica l MRPs the longer the time period the b etter. Data is ava ilable from1883 to the p resent . A recent pap er (Bra ilsford e t a l 2008) reviewed da ta p rior to 1958 and

questioned its app rop riateness in reflec ting a b roa d market return. Afte r a be st effortsadjustment to this data by the authors, the historical MRP over this period (1883 1957) was6.1% compared w ith 8.0% from the p rior Office r una d justed da ta . Whether of not theBrailsford et al adjustments are appropriate does not change our view of therecommended MRP.

The market risk premium o f 6% wa s origina lly ba sed on evidence tha t exc luded anyexplic it c onside rat ion of a compo nent to reflec t any va lue of imputa tion tax benefits in thehisto rica l MRPs. Co nseq uent ly the 6% can be viewed as an estima te of the MRP whe n thisvalue is zero (the term gamma is usually used to reflect the value of $1 of imputation taxbenefits created by a firm however we are concerned with the value of a dollar ofimputation tax benefits once distributed given that we are adjusting observed market

returns). The inclusion of an estimate o f the imputat ion tax benefits in the historica lestimate of market equity returns forms the basis of our recommendation that the MRP beincreased from 6% to 7% as qua lified below.

We recognise that precise estimation of both the MRP without imputation tax benefits andthe estimation of imputation tax benefits is a challenge due to noise in historical data.An overlay of the need for regulatory certainty encourages us to recommend that therebe no change in the widely used 6% under a view that imputation tax benefits have novalue but it this is not enough to prevent our recommendation of 7% when imputationbe nefits are inc luded. While we have not foc used on estima ting an explic it value ofgamma or the value of imputation tax credits once distributed in this paper, regulatoryprac tice p lac es a va lue on gamm a of 0.3 and greate r. Unde r these c ircumstances we

rec om me nd the MRP be 7%.

A number of suggestions have been made as to why there may be reasons to lookbeyond a long historical series of observed MRPs to arrive at an estimate of the MRP.These inc lude sugg estions that struc tural c hang e ma y have oc curred and there arehistorical events that may not be repeated and should be excluded from the MRPestimation. Afte r review ing the se sugg estions in light o f our da ta , we are of the view tha tlongest time series should be used and that there should not be any removal ofob servations be cause p ast eve nts ma y not rep ea t.

1 The sta tistica l prec ision of the estima te is low g iven the h igh va riab ility in the historica l da ta .


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Contents

1. Introduc tion ...........................................................................................................12. Guidanc e from the Theory..................................................................................23. Estimating a Market Risk Premium......................................................................5

3.1 Introduc tion ...........................................................................................................53.2 Me asurement Issues.............................................................................................5

4. Review o f Prior Research .................................................................................. 124.1 Histo rica l-based Research ............................................................................... 124.2 Forwa rd da ta based Resea rch ....................................................................... 134.3 A summ ary of M RPs used in reg ulato ry p rice de terminat ions

in Austra lia ........................................................................................................... 164.4 A Summary of Survey Evidenc e ...................................................................... 16

5. Update of Histo rica lly-based Ma rket Risk Premium...................................... 195.1 Historica l Regula to ry Perspec tive.................................................................... 195.2 Data and Ap proac h ......................................................................................... 195.3 Results and Comparisons ................................................................................. 22

6. Further Issues in Estima ting an MRP................................................................. 276.1 Introduc tion ........................................................................................................ 276.2 The length o f time ove r which the MRP should be estima ted ................... 276.3 The va riab ility in MRP ove r time and the cha lleng e o f ident ifying

struc tural shifts..................................................................................................... 296.4 Ad justing for drivers of stoc k market p erformanc e tha t ma y not rep ea t 37

7. Conc lusion.......................................................................................................... 398. References.......................................................................................................... 41


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1. IntroductionA basic tenet of finance theory is that investors act as if they require a reward for bearingrisk. The req uired rewa rd is usua lly expressed in terms of a positive p remium over a riskfree rate of return2 for investing in assets eithe r rea l or c laims on rea l assets suc h a sfinanc ial assets.

The required tota l reward for ca pital bea ring risk and the t ime value tha t c ap ita l is tied upin assets or projec ts can be expressed in the c ost o f cap ita l of the a sset o r investment. Thecost o f c ap ital is an input to price d ete rmination hea rings in a number of reg ulato ry p rice jurisd ictions in Australia. These d ete rminat ions c onsider a return on cap ita l to be anappropriate economic cost of doing business and an estimate of it is built in to anassessme nt o f regulato ry revenue req uirements3.

The ove rarching guide for assessing this cost o f c apita l is tha t it should reflec t the ra te ofreturn required in a competitive capital market that is supporting investment in real assets.Current theories suggest that this required rate of return should be independent ofow nership. Reg ulato ry bod ies in Australia look to a com petitive market to guide a nassessment of what the appropriate cost of capital should be for assets over which they

influenc e the pric ing or outputs. The c ha lleng e for regulato rs is to e nsure the cost ofcapital is set to earn investors a competitive rate of return to encourage investment butnot lead to monopolistic pricing while providing an incentive to improve overallperformance.

The c ost of e quity, as a comp onent of the w eighted average (of deb t a nd e quity) cost ofcapital, is not directly observable. It is generally estimated using the capital asset pricingmo del [CAPM ]. The CAPM de sc ribes the c ost of equity cap ita l as eq ua l to the risk freerate of return plus a p rem ium for the risk of the equity invested. This p rem ium is a func tionof market risk premium [MRP] times the relative risk of the equity compared with the riskof the m arket (beta of eq uity). As a conseq uence, the MRP is an important input to p ricedeterminations.

The p aper exam ines the MRP in Austra lia , prima rily from the perspec tive o f investing in longterm assets. An ove rlay is a regu lato ry pe rspec tive howeve r the overlay does not a ffec tour evaluation and update of available evidence or our review of an historical andforwa rd looking pe rspe c tive of the MRP4.

This doc ument is struc tured to : summarise our f indings; summarise guidance from the theory as to how to think about and estimate

the ma rket risk p remium; rev iew issues in me asureme nt; review a nd up da te historical evidenc e tha t guides a view on MRP; review forwa rd looking evidenc e a nd rec ent resea rch in this reg ard; and to present o ur point of view as to the most approp riate M RP.

2 There is no such thing as risk-free return, when the fina nc e literature ta lks of a risk-free ra te they m ea n a ra te tha t

reflec ts low a nd relatively constant risk suc h as the rate o n go vernment b ac ked (in their c urrenc y) pa pe r (de bt).3 For examp le the Annual Reve nue Req uirem ent(ARR) of a viab le co mp any m ust be e qua l or grea ter than the:

operating costs + depreciation + cost of capital (the required return on capital times the value of capital) +effective tax.

4 We use the term Ma rket Risk Premium (M RP) to refe r to b oth a forwa rd looking a nd historical c ontext. Som e use

the te rm exce ss ma rket returns or ma rket exc ess returns to refer to the historic al d ifferenc e b etw een the

ob served return on the m arket and the risk free rate . We do not use this term.


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2. Guida nc e from the TheoryUnder the simplest ve rsion of the Ca p ita l Asset Pricing M od el [ CAPM ]5, investors choosea p ortfo lio of assets tha t ma ximise the ir return for a c hosen leve l of risk. With the existenc eof a risk free asset, all investors will choose some combination of the risk free asset and amarket portfolio6. The m ix of the risk-free asset a nd the market portfolio w ill dep end upo nindividual attitudes to risk.

With this outcome, the risk of any particular asset will be its contribution to the risk of thema rket po rtfolio. The individual asset s cont ribution to the risk of an effic ient po rtfolio(the market portfolio) can be shown to be covariance 7 of the assets returns with thema rket s return ra ther tha n the individua l varianc e o f the asset s returns. The tota l risk of a nasset from an investors perspective is not the relevant risk it is the sub element calledsystematic risk or covariance risk which is the risk that contributes to the non-diversifiablema rket risk. This system at ic risk when d ivided by the va rianc e o f the m arket p ortfolio isreferred to a s be ta.

The CAPM is a forwa rd looking c onc ep t b ut b ec ause of the lac k of reliab ility in forec astmodels the parameters are generally estimated by reference to historical returns8. It is

com mon for MRP to be estimated in this wa y. We elaborate o n this point la ter in thepaper.

The CAPM d esc ribes the p ricing of assets in the follow ing w ay9.

E(ki) = rf + E(MRP) i (1)

Where:

E(ki ) is the expe c ted rate of return from investing in the asset ;rf is the risk free rate;E(MRP) is the expec ted market risk premium and it is positive;

i is the beta or risk of the asset relative to the market (It reflects the relativecont ribution of the a sset to the risk of the ma rket).

Some key features of the mode l for the purpose o f this pa pe r are that it:

is forward looking defines a positive reward for bearing risk i.e. a market risk premium will be

positive is a one pe riod mode l of no p articular time dimension; applies to a ll assets which a lso de fines the ma rket p ortfolio.

The m od el is relat ively unc om plica ted howeve r it lac ks spec ificity if it is to be used inprac tice. A numb er of questions need to b e a dd ressed when using it, for exam ple:

What is the length of the one p eriod ?

5 The mo del generally attributed to Sha rpe , Lintner, Mo ssin.6 The p ortfolio m ust lie on the efficient set , the p ortfolio usually cho sen is a broa d ba sed share m arket po rtfolio,

eac h share weighted by c ap italisation.7 Cova riance c an b e thought of a s how that return on an a sset c hanges when the market c hanges. Not all the

c hang es in an a ssets return are d ue to the m arket. The CA PM foc uses on the eleme nt of m ove ments in returns

related to ma rket movem ents.

8 This is d isc ussed furthe r in Sec tion 3.1 on page 59 The symb ols are similar to those in the Issues Pap er howe ver we hav e d eliberately include d the e xpec tat ions

op erat or E for emp hasis. The m od el we refe r to is the same a s tha t referred to in the Issues Pap er (e.g. pa ge 6).


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- Conceptually it is the price setters horizon but typically there is anassumption of some match between the asset life and investorsp lanning horizon. Returns are usua lly expressed per annum returns.

What is the ma rket?- Conceptually it is all assets, however practically it is assumed that a

broad ly ba sed eq uity ma rket inde x is a go od proxy. What is the expected return on the market, or the MRP, given the risk free

asset?

- The emphasis should be on a forecast o f the ma rket risk premiumhowever, in practice, it is estimated with reference to historical returnson the grounds that these influence investors view of the future andthat there is no b ette r forec asting m od el ava ilab le.

- There is also a need to spec ify the ta x sta tus of the return on the m arketand the c omp onents of the return. The ob servable return on an equityma rket index is after corpo ra te b ut be fore pe rsona l ta x. The existenc eof a n imputa tion tax system mea ns that , if the be nefits are va lued , theyshould b e include d in the index as a c om ponent of the return. This flowsfrom corporate tax really representing a pre-payment of personal taxfor investors who can ac cess the imputation ta x reb ate .

What is be ta of individua l assets? How to e stima te it?- Typica lly the ma rket mo de l10, which can be thought of as consistent

with an ex post (or empirical analogue) version of the CAPM, is used toestimate beta by a linear regression11 the historical returns of a stockaga inst the ma rket s returns.

- There is a p articula r cha llenge in estima ting betas for unlisted businessesor business units of a mu lti-business unit c om pany.

All of these que stions have been sub ject to considerab le deb ate and resea rch. Arisingfrom this research, some near conventions have been established by academics,p rac titioners and regulators but there remain ma ny areas of judgment. Since the focus ofthis study is the MRP (market risk premium), we summarise the areas we take asconventional and highlight the areas where we need to exercise judgment and what thetrad e-offs might b e.

Areas where c onvention ha s arisen

Area Near Convention

Long te rm investo r horizon 10 yea r view for risk free rate and MRP

Period of estima tion of MRP Annua l

Metho d of ave rag ing when using historical da ta Arithmet ic average

Ma rket po rtfolio of risk assets Rep resente d by a b roa d dom esticeq uity market index.

10 The m arket mo de l is simply an a lgeb raic relationship b etw een t he return on an a sset a nd t he return on the

ma rket g enerally expressed as ~r~r~ mi ++=

11 Usua lly, bu t not nec essarily, by using the sta tistica l tec hnique c a lled Ordina ry Lea st Squa res regression


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There are a num be r of a rea s whe re som e element o f judgm ent is req uired to fo rm a viewabout an appropriate MRP to use when applying the CAPM, especially in a regulatoryenvironm ent. These will be addressed late r in the p aper and inc lude:

Areas generally requiring judgme nt

Area Comment

Weight to place on historicalversus forward looking estimates ofMRP:

The use of ob served or histo rica l MRP as a forwardlooking estimate assumes the past will repeat itself,that investors view of the future is based onexperience and that there has not been anysignificant structural change in the forces thatdete rmine a MRP.

Ac curac y Observed MRPs have a large standa rd de viation orvarianc e m aking a ccurac y to multiple dec ima l pointssugg est a de gree of a ccurac y that isnt rea lly there.

The bene fit of reg ulato ry ce rta inty(especially stability in parameters)versus variability due to short termma rket movements:

Placing a high value on regulatory stability meansthere has to be compelling evidence beforechanging a parameter such as the MRP, once it isestablished.

The va lue o f imputa tion taxbenefits:

It is c lear that these a re o f va lue to d omestic investo rsbut no t to foreign investors due to the lac k of a direc tma rket for imp utat ion tax benefits. We d o not forman explic it view ab out their va lue in this pa pe r.


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3. Estimating a Ma rket Risk Premium3.1 IntroductionThe m ost c ritica l pa ram eter of the CAPM a nd its compo nents is the e xpe c ta tions op erator(E). The expec ta tions op erator should be thought o f as the me an or average of themarkets forecast of future or required (expected) returns before they will invest in the

eq uity of a p articula r risk c lass. Idea lly, what we need is some me thod of forec astinginvestors expectations or equivalently their required returns for the different risk class ofassets. Unfortunate ly, while suc h mod els exist, they req uire additiona l assumptions aboutinvesto r be hav iour and rarely have very much to offer in the way of forec ast-ab ility. In aninvestment environment, this is perhaps not surprising insofar as if there were forecastabilities in these models then this would remove elements of risk and make the modelsred undant insofa r as they a re based on risk or stochastic returns.

In such circumstances, it is perhaps inevitable that forecasts, in order to be objective, relyhea vily on histo rica l da ta . The reason for relying on such da ta is tha t the expec ta tions ofinvestors will be framed on the basis of their experiences, which are of course historical.Therefo re the mea n of histo rica l distributions of retu rns or models framing returns could be

expected to have had the greatest influence on investors expectations about the future.Henc e the reliance on som e a verag e o f histo rica l MRPs in order to sett le on a n estimate ofthe investo r s expe c ted or req uired MRP.

Under these circumstances a longer time series is best as it will not only improve statistical ac curac y but also best weight events ac c ording to the likelihood of oc currenc e. Forexample, a short time period that incorporates the 1987 crash could potentiallyoverweight that eve nt co mp ared to its likelihood of oc currenc e.

An alternative approach to estimating a MRP from historical data is an explicit forwardlooking app roa ch. Typ ica lly this involves firstly de riving the implied req uired rate o f returnon e quity from the c urrent share p rices of a sec urity and ma rket partic ipa nts expe c ta tions

of the future ca sh flow s. This is then ag greg ated ac ross a ll stocks to p rovide and e xpec tedma rket return. The third step is to d ed uc t an estima te o f the risk free ra te to d erive a forwa rd e stimate o f the MRP. These app roa ches are hea vily reliant upo n, and sensitiveto, the forecast c ash flows, usually rep resented by a growth rate. Ac c ording to Gray(2001), the sensitivity of the MRP to these forecasts does not provide a statistically tighterestimate than the histo rica l series. As note d by G ray:

When we recognise the uncertainly surrounding the estimation of the

components of the dividend growth model, it is clear that this models

estimate of the market risk premium is even more imprecise than the

estimate obtained by using historical data. P8

This sugg ests forwa rd loo king m ethod s don t g ive a m ore p rec ise estima te then one b ased

on histo rica l da ta . Conseq uently our p rimary focus in this pape r is forming a view a boutan appropriate MRP for price determinations derived from historical data.

The em pirica l resea rch using each of these two approa c hes is reviewed after exam ining anumber of measurement issues.

3.2 Measurem ent IssuesThis sec tion of the p aper ad dressed a numb er of the impo rtant mea surement issuesassoc iate d with estima ting a MRP. In particular it addresses:

- Arithmetic versus ge ometric m ea surement of returns;- The t ime pe riod to c onsider when estimating a n MRP from histo rica l da ta ;- Matters dealing with the measurement of market return the choice of a

market index including equal versus market weighted;


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- The m aturity a nd nature o f risk free ra te to use;- The t rea tment o f imputa tion ta x credits.

3.2.1 Arithme tic and Geom etric Mea surem ent for ReturnsGiven the view that the expectations of investors will be framed on the basis of theirexperiences, the question then arises as to which average or more accurately which

me asure o f cent ra l tend enc y of the d istribut ion of the historica l returns should b e used ? Byconvention academics and practitioners usually select the mean of the distribution butthere is no strong theoretical reason12 why this should be selected over the mode ormedian to represent the effect of history on current expectations.

The arithmetic average or mean market risk premium is usually used on the basis that weare seeking a n estimate o f the expec ted return on a b roa d m arket of eq uities. If allhistorical observations were treated as independent draws from the same distribution, theap propriate estimate o f the expec ted value is the arithme tic mea n.

However, in some c ircumstances, a g eom etric mea n is computed 13. The geom etric meanis always less than or equal to the arithmetic mean, it is only equal when there is no

variation in the historical returns )0( 2MRP = but as the variability in returns increases

)0( 2MRP

the sma ller the ge ome tric mean b ec ome s relative to the arithme tic . The

geometric mean represents the actual investment returns over a defined period and isappropriate when estimating the aggregated return achieved from a buy and holdstrategy, but that is not the purpose here, where we are trying to find the bestrep resentat ion of how expe c ta tions a re fo rmed o n pa st historica l returns.

The MRP is to be used in the CAPM to compute the c ost of e quity expressed in annua lte rms. Therefore, we require a n estimate o f the expec ted return, on a n annua l basis of themarket portfolio ))r(E( m over and above the risk-free rate (rf). What return do we expect

on the ma rket portfolio over the next pe riod, relat ive to the risk-free rate? The historica l

data provides us with many observations on what the market returned relative to the risk-free rate over a series of one-yea r period s. To the e xtent tha t ea ch of these should b egiven eq ual we ight in fram ing e xpec tat ions, a simp le a rithmet ic ave rag e is ap prop riate.

There a re further prob lems bec ause the d istribution o f returns is not sta b le14. The lack ofstability means that the standard statistical tests of significance of a mean from observedvalues cannot b e relied upo n.

3.2.2 Time Period under ConsiderationHowever, having a basis for choosing an average of an historical series does notove rc ome the prob lem of w hich a verag e from the d istribution of histo rica l excess returns is

ap propriate to reflect investors expec ta tions. Onc e a ga in theory is of little help a nd theconventional practice has been to choose an arithmetic mean of annual MRPs basicallybecause these observed excess returns are usually publicised as annual rates.Consequently this information can be expected to have a more profound effect oninvestors expectations than shorter periods such as monthly rates return or indeed longerperiods suc h as 5 or 10 yea r rates of return. Of c ourse, if the d istribut ion of e xcess returns

12 The m ost c om pe lling reason to use a n av erage rather than the other me asures of c entral tende nc y is its

mathem atica l trac tab ility.

13 The a rithmetic mea n return rm is ca lculated a srm = n

n

1imir

= , whereas the g eome tric mea n Rm is ca lculated as

0.1n

1i

)n/1(m )r1(R mi = +

=

14 From the c ontext of known ma thematica l func tions that c an b e used to a pp roximate returns.


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wa s a sta tionary over time then it w ould no t m atter whethe r monthly, annua l or 10-yearlype riod s we re c hosen a s a sta tionary or stab le d istribution would mea n tha t the pa ram eterswere invariant over various time periods and that one year rates would be simply aproduc t o f mo nthly rate s and in turn 10-yea r rate s a produc t o f a nnual rate s.

The further question in the c onte xt o f histo rica l returns is how fa r back should we go inretrieving d ata o n retu rns? The longer we go bac k in time then p ote ntially the less releva nt

the d ata is likely to b e fo r tod ays c ircumsta nces. This is bec ause of p ote ntial cha nge s inunderlying economic factors such as the structure and efficiency of capital markets,change s in the o pportunities to d iversify risk ac ross count ries, be tte r informa tion p rod uc tionetc . Howeve r if we shorten the time p eriod for estima ting the MRP then the high variab ilityin observed returns me ans tha t we w ill have an estima te with p oo r sta tistical reliab ility. Theaverage will change from period to period, this means that the shorter the time periodused to determine an average, the less chance of finding an estimate that is sufficientlystable for use a s a surrogate for current expec tat ions. The p rac tice ha s be en to ad op t 5and 10 yea r moving ave rage s and examine them fo r stab ility of the MRPs. Moresop histica ted ma thema tica l mod els such a s exponent ial smoothing ha ve also been usedto try and find som e sta bility in the estima te.

In our view , which has be en c onfirmed b y the data we have examined, we should use thelonge st time series possible, sub jec t to minimising d a ta measurement errors, to estimate theMRP.

3.2.3 Mea surement of Market ReturnThe market return or ma rket fa c to r used in the CAPM a nd MRP is the rate o f return on abroa d share ma rket index suc h a s the All Ord inaries of the Australian Share Ma rket o r theS&P 500 Index of the New York Stock Exchange. The return is me asured a s anac cumulation inde x, mea ning it includes divide nds as we ll as price chang es, for exam plethe return for a single period i (of no fixed d imension) for stock or index j is defined as:

j,1iijj,1iijij p/)dpp(r +=

Where p ij is the p rice (ex-divide nd if any) a t the end of p eriod i and p i-1,j is the price at theend of the previous period (start of the new period) for stock or index j and d ij is thedivide nd (or cash) that is assumed to o ccur at the end of the pe riod i.

The g rea ter the freq uenc y with which rij is measured the greater accuracy because of theassumption that d ividend s are paid a t the e nd o f the p eriod . Shorter pe riod rate o f returncan be simply compounded to give a longer period rate of return e.g. a four period rateof return is the p rod uc t of each of the fo ur period rates of return, i.e.

0.1)r1)(r1)(r1)(r1(r 432141i ++++== .

When forming an index of stock returns there has been some discussion about theap propriate we ighting that should be used on the stoc ks ma king up the index. Forexample the e arly accumulat ion inde xes suc h as CRSP in the US (Centre fo r Resea rch inSec urity Prices) index an eq ua l weight ing of stocks ma king up the index wa s used .However, the theory underlying CAPM is unambiguous; the index representing a marketfactor should be represented by all assets in the economy weighted by their relativevalues.

Therefore the index should b e a va lue weighted index rep resenting the b roa dest(preferab ly a ll) sec to rs of the economy. In fac t nea rly all estimates of the m arket riskpremium have been using va lue weighted inde xes.

3.2.4 Maturity a nd Nature o f the Risk- free RateThe eq uations for CAPM a nd MRP have be en d efined in the c ontext of a pa rticular pointin time , but this does not imp ly there is any de fined t ime period for the mod els. The the ory


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does not specify any time period for the models the CAPM is applicable to a single timepe riod o f unspe c ified length. As a c onseq uence, there has be en quite a dea l ofcontroversy and va riat ion in the t ime pe riod used to estimate the pa ram ete rs of the CAPMused in prac tice. Insofa r as the surrog ate fo r the risk free ra te ha s been a 10 yea rgo vernment bond yield , this wo uld imply a 10-yea r planning horizon. The reason tha t a 10year yield has been adopted is because most of the projects for which CAPM has beenused as a me ans of estimating the req uired return on eq uity have be en long term projec ts

and it would be a mistake, in these circumstances, to use short dated governmentsec urities as the risk free rate surrog ate. Idea lly a much long er maturing go vernmentsec urity would be used but the ma rket fo r such instruments is qu ite thin and the yields ma ybe an unreliable basis for use as a proxy for the risk free rate of return.

On the other hand, those who do use shorter-term government bill rates often point to thefact that traders in equity markets are basically setting prices and these people have shortterm p lanning horizons. The response is tha t the investment p lanning by corpo rat ionsshould not be affected by short term market movements and, insofar as their planning islong term, an extended period for the risk free surrogate such as the 10 year bond yield isthe most appropriate.

3.2.5 Treatme nt of Imputation Tax Cred itsAn imputa tion ta x system wa s introd uced in Australia from July 1 1987. A key p urpo se o fthe imputation system was to remove the tax bias against equity income in the priorc lassical tax system and plac e it on the sam e ta x foot ing a s de bt income . The imputa tionsystem remo ved the d oub le ta xat ion o f d ividend income und er a c lassica l tax system forAustralian Resident Taxpayers. The c lassica l system taxed e quity inc om e a t the corpo ratelevel and then aga in at the pe rsona l level. Unde r the imputa tion system , corporate taxcan be viewed as a collection of personal tax for those subsequently claiming theimp utat ion tax b enefits.

The Australian system has since be en mod ified ove r time in a num ber of wa ys. Som erelevant c hang es are:

A c orporate ta x on supe rannua tion funds wa s introd uced from 1st July, 1988 toenable them to use imputa tion tax bene fits and to remove any d isincentive toinvest in c omp anies pa ying imp utation b enefits;

The introd uc tion of a 45 day holding p eriod a round the d istribution of frankingtax cred its in 1997 which imp oses add itiona l c ost on t rad ing in cred its;

A move to a rebate rather than tax credit system in July 2000 which enablesdomestic tax exempt and low taxed residents to now fully access imputationbenefits.

An outcome of the imputation system is a differential effect across some shareholdergroup s. The b ene fic iaries a re, in the broa d, individua ls and superannua tion funds

whereas foreign investors and tax-exempt shareholders (historically) did not gain directlyfrom the c hange . As a result, the ne t dolla r return afte r ta x these d ifferent shareho ldersgroups ea rn c an differ.

The term ga mm a has be en used widely to reflect the va lue of a d ollar of imp utation taxbene fits. It is used to ad just e ither the ta x rate in after ca sh flow e stimation o r to the c ost o fcapital when undertaking project or enterprise valuations or when assessing regulatoryrevenue requireme nts. However we d o not use ga mma but rathe r a c ompo nent of it toad just for the impa c t o f imp utat ion ta x benefits on mea sures compa ny or market returns.

To exp lain our ad justme nt and its relat ionship with ga mm a, we draw on the desc ription ofthree milestones in the life of an imputation tax benefit as described by Hathaway and

Off ice r (2004).


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1. It is created when c omp any tax is pa id;2. It is distributed when company tax is paid to shareholders as an attachment to

dividends;3. It is redeemed when shareholders c laim the rebate a nd e njoy the t ax be nefit.

Comm on usag e is to d efine ga mma () as the value of a dollar of imputation tax benefitwhen it is created. A do llar of imp utation tax created w ill be reta ined (a nd tracked as a

FAB - franking account balance until it is distributed by way of an attachment to ad ivide nd. The imputa tion tax be nefits a re of d irec t inte rest to shareho lders onc e they a red istributed . Thus whe n looking a t the retu rn shareho lders rec eive from their investmentove r a p articular pe riod , we a re interested in c ap ita l gains, divide nds and the imputationtax be nefits att ac hed to d ividends.15

The relationship be twe en g am ma and the va lue o f imputa tion tax benefits distribute d iscap tured in equa tion (3).

= Fx (3)

Where F is the proportion of imputation tax benefits created that are distributed

(attac hed to dividend s)

is the va lue of a n imp utation ta x be nefit that has be en d istribute d. Wede fine this to b e the va lue on the d ay tha t the stoc k bec omes ex dividend.

Dividend drop-off studies estimate a value for .

Regulatory bodies have used a value of 0.5 for gamma to adjust statutory tax paid toreflec t the a mo unt tha t is d istributed and used by shareho lders. How eve r our interest

whe n a d justing o bserved ma rket returns for imp uta tion ta x benefits is in .

Hathaway & Officer (2004) estimate a value of 71% for F from tax statistics and a value of

0.5 for from their dividend d rop off empirica l wo rk. Thus they sugg est a va lue for ga mm a

of 0.355 being the p rod uc t of these two numbers. Values for these te rms are sub ject toconsiderab le unce rta inty, measurem ent e rror and resea rch. It is not our intent to reviewthis resea rc h or form a view on va lues for these te rms. Instead we estimate a total ma rketyield for imputation tax benefits to add to the MRP estimated from historical data based

on a range of p ossible va lues for .

As noted , under a d ividend imp utation ta x system, there a re p otent ially three componentsto the return received by equity holders dividends, capital gains, and imputation taxbene fits. In this sett ing , the approp riate measure o f MRP is one tha t includes a ll threecom ponents. This point is c learly demonstrated in Officer (1994) and reinforce d b y Grayand Hall (2006). How eve r, sta ndard stock ma rket ac cumulat ion indexes reflec t dividend sand c apita l ga ins only. Conseq uently, the va lue of franking c red its should, in theo ry, be

added to t he histo rica l estima tes of stoc k index returns a fter the introduc tion of the systemin July 1987.

There is a p rac tica l cha lleng e in estima ting the va lue of these imputa tion tax be nefits andthere is no single precise and robust estimate that is universally viewed as being correct.For these reasons, it is common not to include a value of imputation tax benefits whenconstruct ing stock return inde xes.

15 Any value to imputation tax benefits retained will be reflected in the share price through an anticipation of

when the y ma y be d istribute d a nd the ir va lue at this time.20 See Hatha wa y a nd O ffic er (2004) for examp le


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It is not within the scope of this paper to estimate a value for imputation tax benefits.However we do include imputation tax benefits in the market return for a range of possiblevaluations of them where the valuations are derived from regulatory practice andempirical studies20 to show the impac t on the MRP. For exam ple, we estima te theadjustment to be 85 basis points for a value of 0.5 for the imputation benefits oncedistributed.

In addition, regulatory and market practice 21 is to c ompute an e stimate of MRP ba sed onhistorical data, but to adopt a final estimate that reflects appropriate judgment aboutother information such as recent trends, changes in the market, survey evidence,evidenc e from va rious ec onom ic mode ls and so on. These judgments and the lack ofprecision in the average arising from the high variance in observed MRPs explain whyregulatory and ma rket p rac tice has be en to use a n estimate of 6% even though historicaldata from the last 30, 50, 75, or 100 produc e estima tes tha t a re highe r. In our view, takingthe MRP to a decimal point could give an impression of accuracy in the estimate that ismisleading.

While any likely adjustment to reflect the value of imputation tax benefits is going to besma ll, in our view it may be large enoug h to support a c hange in the historica l use o f 6%.

Nonetheless, following the approach to adjusting MRP for imputation tax benefitsindicated by Officer (1994) where their value is added to the markets expected rate ofreturn a post imputation tax estimate of the MRP can be obtained 22. The ad justmentrequires:

1. An estimate of the dividend yield (d i) comp onent of the total or cumulative yield(ri) made of the capital yield (p i) plus the d ividend yield for the pe riod (i). Theimplicit company tax paid on this dividend is estimated i.e. the dividend yield isgrossed up (divided by 1.0 less the com pany tax rate i.e. (1- Tc )) and then the taxcomponent is estimated by multiplying the grossed up dividend by the effectiveco mpa ny tax rate;

2. Since no t a ll d ividend s are franked d ividend s, the p rop ortion of franked d ividend s(f i ) has to be estimated. Multiplying this by the implicit company tax paid on thedivide nd g ives the effec tive tax imp lied o n the divide nd;

3. Finally, since not a ll investo rs va lue imputa tion ta x benefits onc e d istributed a t the irface value, see Hathaway and Officer (2004), an estimate of the value ()implied by the market of a unit or $1 of franking c red its must be estima ted .

The net result of these proc ed ures is an estimate of the va lue of franking c red its (VFC i) inthe return to investors for the period i, i.e.

ii dVFC = .f).T1

T( i

c

c

(4)

We focus on estimating a market return that included a value for imputation tax benefitsthat a re atta ched to d ivide nds pa id.

The relationship o f our ad justment to Off ice r (1994) and Gray & Hall (2006) (who a lsorelates the relationship to Lally research) is demonstrated by equation 18 from Gray andHall (our equa tion (5) below). This desc ribes the relat ionship betw een the o verall returninvestors receive ( tr' ) and the return that is captured in stock market indexes which

excludes any rec ognition of imputation ta x bene fits.

21 See ag ain Truong , G., Parting ton , G. and Pea t, M. (2005).22 Gray a nd Hall (2006) present the m athe ma tica l relationship be twee n the va lue of franking ta x benefits and the

MRP. The ir ad justm ent is c onsistent w ith ours.


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1

'

+=t

ttt

P

Crr (5)

Here1t

t

P

C

is the imputation tax benefit yield for benefits created

Substituting equat ion (3) for yields

1t

ttt

PCFr'r

+= (6)

Where the last two terms [1t

t

P

C

] refe r to imputa tion tax benefits d istributed . Since we

estimate these from dividends that have been distributed then we are interested in

adjusting this yield by not. 23

Estima tes of the VFC fo r the thirtee n yea rs from 1993 to 2005 indica te an averag e va lue for

the VFC of 85 basis points if the value of a dollar of franking credits distributed () is 0.5.This wo uld sugg est an inc rea se in the ma rket rate o f return for the p eriod by a n average o f

0.85%. For examp le if the MRP for the period or the e xpec ted M RP was 6% the n it shouldbe a d justed to 6.85% for the effe c tive va lue of the franking c red its. This is not a largeam ount a nd w ell within the range of standa rd m ea sureme nt errors one m ight e xpec t fromestimates of the MRP. How eve r, on the ba sis of such an estimate , given a va lue of 0.5 forimputat ion ta x cred its d istributed , in our view an MRP of 7% is more justifiable tha n one of6%. Ad ded streng th for this view a rises from mo st histo rica l averages (ac ross d ifferentperiod s) be ing g rea ter than 6%.

We provide m ore de ta il around the estimate of VFC in a late r sec tion.

23 There is a p ote ntial log ica l inc onsistenc y in prac tice. Ma rket returns are me asured as ca pital ga ins plus

d ividends. The full va lue of the divid end is includ ed d espite stud ies showing the se are not nec essa rily fully va lued(the price d rop off is less than the a mo unt of the dividend ). We are not inc luding the full am ount of the

imputa tion tax benefit but a djusting it by .


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4. Review of Prior Research4.1 Historica l-based ResearchEmp irica l resea rch in Australia has a lmost exc lusively examined the histo rica l be hav iour ofsto ck market returns relative to Treasury bond , or in some c ases Treasury bill, returns. Theexception is a forward market risk premium estimate available from Bloomberg.

Most histo rica l stud ies have a ge nesis in da ta prep ared by O ffice r (1989). Officer comp ileda ma rket rea lised return and risk free ra te series from 1883 to 1987. The d ata p rec ed ed theintrod uc tion of imputa tion tax in Australia. The averag e excess return for this pe riod was7.9%. Subseq uent stud ies have up dated this series, just as has this paper. Subseq uentstud ies inc lude Dimson, Marsh and Sta unto n (2003), Hatha way (2005), Hanc oc k (2005),Bra ilsford, Hand ley and Maheswaran (2008). In add ition there have been pa persprepared for regulatory hearings that update the Officer data, examples include Grayand Off ice r (2005), Bishop (2007).

Ba ll and Bow ers (1986) did not use the Officer series and foc used on the po st 1973 pe riod(1974 1985) determined by preparation of stock data by the Centre for Research in

Financ e [ CRIF ] at the AGSM. This group compute a va lue weighted index of all listedstoc ks in their files rather than the sma ller numb er of stocks tha t a re inc luded in the Sydne yStock Excha nge Indexes and subseq uent ASX and S&P indexes. We ha ve no t c orrelatedthese indexes but a re o f the view tha t the MRPs are no t substantially different. Forexample, Hancock (2005) used CRIF data and compared the MRPs from his data with thatfrom Officer data over the period 1974 to 2003 and the averages were 5.9% and 6.0%respectively (the risk free data was from the same source) and the standard errors werethe same a t 4.3% (verified in this stud y). Since the Ball and Bow ers stud y covered only 12yea rs, we d o no t c omment on it further here.

While the base data sources either correspond or give similar MRPs in all studies, therehave be en some nota ble d ifferenc es in tw o g roups of studies.

1. The first group is Hatha way (2005) and Hanc oc k (2005). These two stud iesadjust the base data for events they believe to be non-recurring and withoutthe ad justments lead to an ove rsta tement of the MRP. Afte r ad justments,Hathaway argues that the appropriate market risk premium is 4.5% which isconsistent with Hancock who argues that the MRP has not been stable overthe prior 122 yea rs and it is in the rang e 4.5% to 5.0%. We com ment o n theap proac h taken by these two pap ers in a later sec tion.

2. The sec ond g roup (of one) is the Brailsford e t a l (2008). This paper investiga testhe sources of data that comprise the Officer series and argue that the pre1958 data has some measurement errors and cannot be relied upon.

Nevertheless the post 1958 data is comparable to the updated Officer dataused in this and other stud ies. Brailsford e t a l make a be st effo rts adjustmentto the pre 1958 market return data and calculate an average market riskpremium o f 6.4% over the period 1883 1987. This is below the a verage of7.8% rep orted by Office r (1989). The d ifferenc e is c learly at tributa ble to the p re1957 period w here the a verages are 6.1% and 8.0% respec tively. The p ost 1957averages (to 2005) are essentially the same at 6.4% and 6.3% respectively.

Given the ab ove stud ies use essent ially the same data source a s this pa per (sub ject to thecomment a bo ve a bo ut Brailsford et al) we rely on our summa ry outp ut a s rep resenta tiveof the results of other resea rch. With the excep tion of the sec tion de aling with imp uta tiontax, we report MRP data that does not explicitly include the impact of imputation tax onthe market return. This is not b ec ause we a re of the view that they have no va lue, theopposite is the case, but rather because we are not taking a position on the value of adolla r of d istributed imputa tion be nefits in this pap er. While we rely p rimarily on the d ata


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used in this stud y, we do draw on the Dimson, Ma rsh a nd Staunton series of pap ers for tworeasons:

because they show Australian data in an international setting; and they hypothesise about future MRP relative to their historical series thereby

providing us with a fram ework to comm ent on these m atters.

We cove r eac h of these p oints in turn.

Dimson, Marsh and Sta unto n (2003) present MRPs (rela tive to long term b ond s) for 16count ries using 102 years of data from 1900 to 2002. This is p resente d inFigure 1 below.

The (unw eighted) average for the 16 countries is 5.9%. The Australian a verage was 7.6%(based on Officer data) and this excludes any adjustment for imputation tax benefits.Twelve of the 16 co unt ries had MRPs grea te r than 5%. The Austra lian histo rica l MRP is atthe higher end but no t d issimilar to the US, South Afric a , Swe den a nd Ita ly ba sed on thesedata but would be around the average using the unadjusted (for imputation tax benefits)da ta from Bra ilsford.

The ma rket risk premium of 6% wide ly used by regulators in Australia is consistent w ith thisworld wide historical view of the average MRP as is our recommendation of 7% whenimp utat ion tax be nefits are inc luded a t a g am ma of greate r than 0.3.

Figure 1: Austra lian MRP in Internationa l Setting

World Market Risk Premia

1900 - 2002

0%

1%

2%

3%

4%

5%

6%

7%8%

9%

10%

Denm

ark

Switz

erlan

d

Spain

Belgi

um

Irelan

d

United

King

dom

Canada

Fran

ce

TheNethe

rland

s

United

States

SouthAfrica

Swed

en

Australia

Italy

Germ

any

Japan

Sourc e: Dimson, Ma rsh and Staunto n (2003). The M RPs are c alc ulate d he re as (1+Mkt Retu rn)/ (1+Rf rate) -1. Thiswill give a slightly different premium that calculated as simply Mkt Return less Rf.

4.2 Forward da ta based Resea rchTyp ica lly forwa rd data b ased resea rch involves firstly deriving the implied req uired rate o freturn on equity from its current share prices and market participants expectations of thefuture cash flows. This is then agg reg ated ac ross a ll stocks (afte r rep ea ting the p roc ess fora ll stocks) to provide a nd expec ted market return. The third step is to d ed uc t an estimateof the risk free rate to derive a forwa rd e stimate o f the MRP.


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A typical example of this approach can be found in Harris and Marston (1999) using USda ta . The underlying mo de l used is generally the divide nd g rowth valuation mod elexpressed in ra te o f return form. The m od el can be expressed as:

re = D1/ P0 + g

where:

re is interp rete d in this approa ch as the internal ra te o f return imp lic it in the p ricing o fthe sec urity g iven the estima tes of the divide nd yield a nd growth rate in d ivide nds

D1 is the next expec ted divide ndP0 is the current share p rice andg is expec ted c onstant g rowth rate in divide nds.

A ma jor cha lleng e w ith this mo de l is deriving the growth rate g. This rep resents theexpected constant growth rate in dividends into the future and the re is very sensitive tothis input. Gray (2003) models a rec ent time series of d ividend yields, inflation a nd GDPgrow th and a fter allow ing for pair-wise c orrelat ions conc ludes (p 23) that :

. . . this models estimate of the market risk premium is even moreimprecise than the estimate obtained by using historical data.

Harris and Marston (1999) estimated g and D1 from a consensus of analysts forecasts atthe individua l stock level. They used consensus forec asts of EPS over five yea rs to derive gand assume this applies in perpetuity. The a ssessme nt o f re is ag grega ted to form a ma rketreturn. A risk free rate is ded uc ted from this va lue weighte d market expec ted return toassess a forward looking MRP.

Harris and Marston (1999) report that the MRP derived in this way varies over their timeperiod o f inte rest (1982 1988), with an averag e o f 7.14%. This, they a rgue isap proxima tely equal to the historical a rithme tic long term d ifferential be twe en returns onstock and long-term government bonds of 7.5%.

To o ur know ledg e there is only one source o f forwa rd looking estima tes of the MRP inAustralia . Bloombe rg fo llow a similar approa ch to Harris and Marston when estima ting aforwa rd looking MRP. Bloombe rg deve lop a ma rket risk premium for a numbe r ofcountries, inc luding Australia , using the forwa rd looking ap proac h a pp lied to the divide ndgrow th mod el. Bloomberg works with ind ividua l stocks in ea ch countrys eq uity index.They use a three stage growth a pproa ch ge nerally transitioning o ver 14 yea rs from a 3yea r nea r term growth rate to a long term or maturity growth rate . The internal rate o freturn is derived from solving for the discount rate that equates the present value of thed ivide nd forec asts with the current sha re p rice . These internal ra tes of return are ma rketcap ita lisat ion weighted to g enerate a n overall ma rket rate of return. The c urrent yield on10 yea r Treasury Bonds is ded uc ted from this to determine a market risk premium.

Unfortunately Bloomberg do not store (or make available) an historical series of thisforwa rd looking m arket risk premium. Neverthe less Allen Consulting Group have c apturedoutput from this service over time and it is reproduced below along with a recentupdate25. We unde rstand that there is no exp lic it considerat ion of imputa tion tax in theseestimates. We are unce rta in as to the d ate of the Allen Consulting Group 2008 numb erbut have ad de d the Bloom be rg num be r as at July 2008.

25 Allen Consulting G roup, Review o f Studies Com pa ring International Reg ulatory Determinations Rep ort to

ACC C, 2004


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Tab le 1: Bloom berg forward ba sed estima tes of MRP

Country Ma rket Risk Premium

2004 2006 2008 July 2008

Austra lia 4.5 4.9 7.9 8.6

Ca na da 6.6 6.6 7.8 6.8

Unite d Kingdom 5.0 5.2 6.3 6.7

USA 5.1 4.5 6.8 6.9Sourc e: Allen Consulting Group, Bloom be rg

Of note from these da ta is the vo la tility in the MRP, as wo uld be expec ted . There is anap pa rent trend up wa rds in eac h co untry but it c ould ea sily cha nge. We d o not d raw anyfirm conclusions from this or the forward looking analysis more generally other than it notp rovid ing a better view tha n the historical series.

The fo rwa rd loo king ma rket risk premium will va ry over time . It is likely that the p remiumderived by the processes described above will differ from period to period as is evidentfrom Tab le 1. Use o f an MRP by reg ulatory autho rities from this sourc e (exclusively) will

involve changing the MRP from dec ision to de c ision. While there may not be anythingwrong with this approach from a purely theoretical perspective, it would require greatconfidenc e in the d erived MRPs to rely upon them . We a re of the view tha t regulatorycertainty that is derived from using an average over time rather than a changing numberis tanta mo unt. There is, in our view insuffic ient c onfide nce in the p rec ision of the MRPsderived by the forward looking approach to warrant a move from the historical averageapproach.


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4.3 A summary o f MRPs used in reg ulatory price d eterminations inAustralia

A market risk premium of 6% has been widely used in regulatory price determinations inAustralia a s is evident in Tab le 2 below. The ta ble ha s be en a dapted from the ESCElectric ity Distribution Pric e Review 2005 and upd ated. Our unde rsta nd ing is tha t these d onot inc lude an explic it a djustme nt for imp utat ion ta x bene fits.

The e stimate has been subjec ted to conside rab le de ba te in the regulatory hearings withargume nt to b oth d ec rea se a nd to inc rea se the MRP.

Tab le 2: Equity p remium e stimates ap plied in Australian reg ulatory de c isions

Yea r Hea ring Rate

2000 ESC Elec tric ity Distribu tion Pric e Review 6.00

2000 IPART AG L Ga s Distribut ion Fina l Dec ision 5.00 6.00

2000 OFFGAR Alinta Ga s Distribution Fina l Dec ision 6.00

2001 ACCC Mo om ba to Ad ela ide Ga s Transmission Final Dec ision 6.00

2001 ACCC Powe rlink Elec tric ity Transmission Fina l Dec ision 6.00

2001 QCA Envestra and Allga s Ga s Distribution Final Dec ision 6.002002 ACCC Elec traNet Elec tric ity Transmission Fina l Dec ision 6.00

2002 ACCC Ga sNet Ga s Transmission Fina l Dec ision 6.00

2002 ACCC SPI Pow erNet Elec tric ity Transmission Fina l Dec ision 6.00

2002 ESC Ga s Distribution Fina l Dec ision 6.00

2003 ACCC Mo om ba to Sydney Pipe line Ga s Transmission Final Dec ision 6.00

2003 ACCC Murraylink Elec tric ity Transmission Fina l Dec ision 6.00

2003 ACCC Transend Elec tric ity Transmission Fina l Dec ision 6.00

2003 OTTER Aurora Elec tric ity Distribution Fina l Dec ision 6.00

2004 ICRC Ac tew AGL Elec tricity Distribution Fina l Dec ision 6.00

2004 IPART Elec tric ity Distribut ion Fina l Dec ision 5.00 6.002005 ESCO SA Elec tric ity Pric e Review Fina l Dec ision 6.00

2005 QCA Elec tric ity Distribution Fina l Dec ision 6.00

2005 IPART Rev ised Ac c ess Arrangem ent for AGL Ga s Networks Fina lDecision

5.50 6.50

2005 ERA Final Dec ision on the Proposed Ac c ess Arrangem ent for theGo ldfield s Ga s Pipe line

5.00 6.00

2005 ESC Elec tric ity Distribu tion Pric e Rev iew 6.00

2006 QCA Ga s 6.00

2006 OTTER Elec tric ity Price Review 6.00

2007 ESC Ga s Distribution Pric e Rev iew 6.00

Source : ESC Fina l Dec ision Elec tric ity Distribu tion 2005 p 365 used as basis and AER Issues Paper

4.4 A Summary of Survey Evidenc eOnly limited insights into the MRP used in practice are available from published research.Survey e vidence is relat ively limited but, in the stud ies we have reviewed , the M RPcom monly used falls in the range 6 8%. The stud ies do not explic itly sta te w hethe rrespo nde nts ident ified a n imp uta tion tax bene fit in the MRP. Twe nty two p erce nt of ChiefFinanc ial Office rs [ CFOs ] respond ing to a survey by Truong et al (2008) use a lowerestima te . This ev idenc e, summa rised below , arises from a survey of CFOs by Truong et a l(2008) and from reviews of independent expert reports prepared in response to takeoveroffers.


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Know n surveys of Australian p rac tice have b een cond uc ted by Kester et a l (1999), Truong ,Partington and Peat (2005), Lonergan (2001), KPMG (2005) and Jardine Fleming CapitalPartners (2001).

Kester et al (1999) surveyed capital budgeting practices in Australia, Hong Kong,Indonesia, Malaysia, Philipp ines and Singa pore. The Australian survey wa s d irec ted a tCFOs and CEOs of a sam ple of c om pa nies listed on the ASX in December 31, 1996. Of the

281 co mp an ies surveyed , 57 respond ed . The survey d id not ask detailed q uestions abo utestimation proc ed ures for estima ting a c ost of equity. How eve r the survey d id reve a l tha t73% of respo ndents used the CAPM for this purpo se. Sixtee n perce nt used the d ividendgrowth rate m od el with 11% a risk premium a dd ed to the cost of d eb t. This outc ome wa sin sharp cont rast to the o ther countries whe re use o f the CAPM was only 27% in Hong Kongand 24% in the Philipp ines with a muc h lowe r usage in the o ther count ries.

Truong , Parting ton a nd Pea t (2005) surveyed 356 listed Australian firms in la te 2004 ab outva rious corpo rate financ e prac tice s. All firms we re c om ponents of the All Ordinaries Indexin August 2004, but no t in the finance sec tor. In a ll, 87 respo nses we re rec eived g iving arespo nse rate of 24%. Usage of the CAPM fo r estimating the cost o f eq uity was essentialthe same as for Kester et al above with 72% of respondents responding in this way.

However their responses are consistent with multiple methods being used for this purposesince 47% also used a cost of debt plus a premium for equity and 34% used the cost ofdebt.

The most c ommo n MRP employed wa s 6% (we assume exc luding imputa tion taxbenefits)26) however more used a rate higher rate than a lower rate . There is no c omm entabout w hethe r this is relat ive to a long term or short term p roxy for a risk free rate. However53% of respondents responded that the MRP was based on traditional standards,consequently we surmise that the MRP is likely to be relative to long term bonds given theAustralian resea rch is focused on th is view . The data from the p aper is p resented in Tab le3 below.

Table 3: MRPs used by ASX 500 CFOsMRP Rang e (%) No. Responses % Rep onses

3.0 5.0 4 11

5.0 - 5.5 4 11

6.0 18 47

6.5 7.0 7 18

7.0 8.0 3 8

Othe r 2 5Source: Truong e t a l (2005)

As note d e arlier, Truong et a l rep orted tha t 85% of respond ents ma de no ad justme nt to

their estimate o f MRP to reflec t the va lue of franking c red its.

Lone rga n (2001) includes results of a review of indep end ent expe rt reports ove r the period1990 to 1999. The only information d irec tly relevant to MRP was tha t only 48 of the 122reviewed rep orted de ta ils of how they arrived a t the WACC. It is a little unc lear as to howmany used the CAPM however it is reported that 42 of the 48 (88%) used the CAPM andma de no a djustme nt for imp utation ta x benefits. Seven (6%) did make a n ad justment forimp utat ion ta x in the valuation b ut there is no c omment on the estimate of the MRP usedor whether there wa s adjustment to the MRP for imp uta tion tax.

26 We consider this assumption reasonable given the generally paucity of data on the amount to include, the

general uncertainty about how to treat the imputation benefits and the widespread use of 6% from survey

evidence.


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KPMG (2005) a lso inc ludes a review of inde pendent expe rt reports. The results a recaptured in Tab le 4 be low. It finds 35 of the 118 rep orts reviewed ove r the p eriod 2000 2005 ap plied a WACC. Of these, 33 ad op ted the CAPM for the c ost of equity. The pa pe ra lso c ap tured the MRP used in these c ases and the results a re reprod uced be low. Noneused an MRP less than 6.0% with the most using that number. 24% used an MRP greaterthan 6.0%.

Tab le 4: MRPs used in Indep end ent Expert Rep ortsMRP Rang e (%) No. Responses % Responses

< 6.0 0 0

6.0 25 76

6.0 6.5 3 9

7.0 4 12

8.0 1 3Source : KPMG (2005)

Jardine Fleming C ap ital Partners Ltd (2001) p resented the results of a survey to Trinity BestPrac tice Comm ittee . The results for Australia a re c aptured in Tab le 5.

Tab le 5: MRPs used by a c ross-sec tion o f different users

Responses Past Equity Prem ium

Ac adem ics 26 6.30%

Brokers 20 5.05%

Asset Consulta nts / Trustees 4 6.67%

Co rporate Ma nage rs 11 6.05%

Tota l Ave rage 61 5.87%Sourc e: Jardine Fleming Ca pita l Partne rs Ltd

We have omitted the data on the expected equity premium (which was an additionalcolumn in the original Table) be cause d iscussion at the Trinity Best Prac tices Co mm itteerevealed that little weight should be placed on the expected equity premium databe c ause pa rticipa nts we re asked the wrong que stion. We a re of the view tha t thegreatest weight should be placed on the groups that are making hard investmentdecisions (Corporate Managers, possibly Asset Consultants) rather same simply makingrec ommenda tions to o thers (ac ad emics and brokers). Not all groups undertake d eta iledvaluations conseq uently without a be tter understanding o f the c ompo sition we hesita te totreat eac h group eq ually.


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5. Update of Historically-based Ma rket Risk Premium5.1 Historical Regulatory PerspectiveA MRP of 6% is wide ly used in reg ulatory price d etermina tions in Australia. The use o f thenumber has be en influenc ed b y the emp irical work of Hathaw ay and Officer27.

Two items of importanc e when reviewing the market risk premium with reference to thiswide ly used number are:

1. This em pirica l evidenc e examined MRPs without any ad justment fo r a va lue forimp utat ion tax b enefits;

2. There is a high deg ree o f mea sureme nt e rror in histo rica l estima tes of M RPs ob served MRPs are ve ry volat ile. As p resente d b elow, the range o f histo rica lMRPs from 1883 to 2007 is from -32% to 54%. In our op inion, g iven th is rang e,prec ision to several dec ima l is not warrante d. Consequently the view wasput28 to early regulatory price determinations and upheld that an integer wasmore ap propriate than a number with a de c ima l point.

While high measurement error remains in the updated MRP estimates below, we allow foran ad justment to reflect the va lue o f imp utation ta x bene fits in our co nc lusion a nd in onesec tion of the ana lysis. Howeve r, including an ad justment for imputat ion ta x bene fitsreq uires a view on the va lue of a dolla r of bene fits pa id to shareho lders. It is not the intentof this pa pe r to form such a view, co nsequently:

We estimate the impact of including a value of imputation tax benefits in theMRP for a range of such va lues;

Much of our analysis and discussion uses historical MRPs that view thesebene fits as hav ing zero va lue. This is not b ec ause we a re o f the view tha t theyhave no value, indeed our view is the opposite, but because we are notdefining a va lue in this pape r. Where inc luding a value for these be nefits

matters to our conclusion we have made it clear that a value has beenincluded.

5.2 Data and App roac hThe h istorica l MRP wa s estima ted annually for the pe riod 1883 to 2007 on a ca lenda r yea rbasis. A monthly series was also estimated from January 1980 to December 2007, the timeperiod simply being the longest for which easily available and consistently determinedda ta w as ava ilab le. It wa s calculated a s the ob served return on a b roa dly based m arketindex less the o pening yield on a p roxy for the risk free rate. In the imp uta tion ta x sec tion,the MRP was also adjusted from 1987 forwards to reflect an estimate of the rate of returnfrom imputa tion tax benefits under different a ssump tions abo ut the va lue of these bene fits.The p ost 1987 pe riod reflec ts the e ntire p eriod for which the imputa tion ta x system hasoperated.

The t ime series of rea lised ma rket returns, imputa tion tax benef its and the risk free rates(the yield on 10 yea r maturing Trea sury bond s), all used to ca lculate the MRP, we rede rived from a number of sources as de sc ribe d be low .

5.2.1 Market ReturnAn equity ma rket ind ex wa s used as a p roxy for the m arket return. The histo rica l series from1883 to 1979 was captured by O fficer and desc ribed in Office r 198929.

27 Mainly unpublished studies given to the regularity authorities.

28 Professor O ffice r wa s involve d in a dv ising Essent ial Services Victo ria .29 Offic er RR, 1989, Rat es of return to sha res, bo nd yields and inflation rates: an historical p erspec tive, in R Ba ll,

P Brown, F Finn & RR Of ficer ed s., Share M arkets and Portfolio Theory. 2nd Edn, University of Queensland Press.


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Annual share returns were constructed from a share market

accumulation index; such an index reflects both dividend returns plus

capital gains. The index was constructed for the period 1882-1987

(106 years) inclusive from a variety of sources. The early period made

use of data developed by Lamberton (1958) and this was linked to an

accumulation index of fifty leading shares from the AGSM price file

(1958-1974) and the AGSM Value Weighted Accumulation Index(1975-1987). The use of different indexes can present problems. There

is always doubt as to compatibility when such a mix of indexes is used.

A large number of checks were made for consistency and

compatibility of indexes. All of the checks suggested movements in

the above indexes were relatively closely and contemporaneously

related.

There are also doubts as to the accuracy of the data in earlier parts of

the period particularly for shares. The base data were monthly share

price data from which annual indexes were constructed adding in

dividends. Using annual data and the various relationships found,

Officer (1985) dispels of the concern about incorrectly drawing

inferences because of poor-quality data, at least on an annual basis.

Brailsford e t a l have investiga ted a m arket return series from Dec ember 1882 to Dec em ber2005 and ha ve a rgue d tha t the series to 1957 may b e oversta ted . The p rimary rea son isthe apparent inclusion of a dividend yield based only on dividend paying stocks rathertha n on a ll stoc ks in the Lam be rton series refe rred to in the Officer quo te. While estima tingand adjusting for a likely size of the error, they cast doubt on the veracity of these dataand, instead focus on series from 1958 to 2005. At the time of writing we have not hadac c ess to these da ta .

The series from 1980 to 2007 was based on the A ll Ord inaries Ac cumulat ion Index, a va lue

weighted index made up of the largest 500 companies as measured by market cap, thata re listed on the Australian Stock Exchange. This index captures a ma rket returncomprising d ividends and cap ita l ga ins.

This index do es not inc lude the a dd itiona l bene fit a rising from imputa tion ta x credits,introd uced from July 1987. As an input to estimating this bene fit, the All Ordinaries PriceIndex was used to derive a d ividend yield from 1988 forwa rd. The d ividend yield wasestima ted by the difference b etwee n the two indices.

5.2.2 Imp utation Tax Bene fitAs noted above, stock market accumulation indices computed in Australia reflect adivide nd yield p lus a c ap ital ga in yield. They do not c onta in any yield from imputat ion ta x

benefits that may have arisen from the introduction of the imputation tax system in July1987.

One reason for the introduction of imputation tax system was to offset the otherwisedoub le taxat ion of dividend s. Under the prior classica l tax system , d ividend s we re ta xedfirstly at the corporate level since they are paid out of after corporate tax earnings andsec ond ly at the p ersona l level since d ividends are treated as taxab le income. Unde r theimp utat ion system, corporate ta x pa id c an b e viewed as a p rep ayment of p ersona l tax forAustra lian Reside nt Taxpa ying Persona l Investo rs (ARTPI). Since we are intereste d inestimating the pre- personal but post- corporate tax rate of return from the market wewould be understating the return by ignoring any value associated with imputation taxbe nefits that could b e att ribute d to pe rsona l tax savings.


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To inc lude a rate o f return for imp utation ta x bene fits req uired knowledge o f the ma rketva lue of these c red its. Since it is beyond the sc op e of this pa per to present a view on thevalue of these c red its30, we have instea d, estima ted a rate o f return c omp onent to inc ludethe market return based on a range of values for a dollar of imputation tax creditsdistributed.

The imputat ion ta x benefit to inc lude wa s discussed ab ove under the head ing Trea tment

of Imputa tion Tax Credits ab ove. The a djustment to the index for the va lue o f the taxc red its from 1988 forwa rd wa s estima ted as follows:

tt dVFC = .f).T1

T( t

ct

tc

. . . (1)

Where VFC t is the estimated rate of return from imputation tax benefits in year t for allstocks in the market index

d t is the dividend yield in the index in year t being a capitalised weighted sum ofindividua l compa ny divide nd yields

ft is pe rcenta ge of d ividend s in the inde x of ma rket returns that are franked (attrac t

an imputa tion tax be nefit)

t is the value o f a d ollar of imputat ion tax benefit that is d istribu ted

Tc t is the sta tuto ry corpo rate ta x rate in year t.

As noted above the dividend yield (d t) for each year was calculated as the differencebetween the All Ordinaries Accumulation and Price indexes and represents the weightedsum o f the d ividend yield on e ac h stoc k inc lude d in the index.

The p ercenta ge of d ividends franked (ft) was estimated in two w ays. In the first case, da tapub lished by the Australian Tax Office on to ta l dividends pa id, broken in to franked andunfranked p rovide d a n estima te for eac h year from 1993 to 2007. A simple averag e of this

perce ntage wa s assume d to app ly in the yea rs 1988 to 1992 for which ta x sta tistics a re no tava ilab le. These data a pply to all companies submitting tax returns which may differ froman estimate based only on the stocks included in the All Ordinaries Index. In the secondcase, the franked dividend percentage for each stock in the index for each year wasextrac ted from Bloom be rg d ata a nd weighted by the stoc ks we ight in the index. Thisbe tter aligns the franking tax credit w ith the divide nd yield in the index.

The va lue of a do lla r of imp utation ta x bene fit d istributed (t) was not formally estimated.Instea d we c hose values to illustrate the impa c t of an imp uta tion tax adjustment. Inparticular the va lues of 0, 0.5 and 1 we re selec ted . Zero is a na tural outc om e of excludingimputation tax benefits, 0.5 is the value used in a number of regulatory pricede terminations for gam ma (here it is used as the value of a do llar of imp utation ta x credit

distributed) and 1 is the o ther extrem e (and unlikely31) value.

The c orporate ta x rate in eac h yea r (Tc t) used was the statutory rate applicable from Julyof the year examined. The c orporate ta x rate wa s ob ta ined from the Australian Tax Officewe bsite. There a re a numb er of po tential inac curac ies here that w e have ignored. One isthe fac t that the ma rket rate of return wa s ba sed on a calenda r yea r whereas the ta x rateis based on a financ ial yea r. This ma y lea d to a sma ll inac c urac y in years when the ta xrate c hanged

30 A sep arate pa pe r is be ing prep ared fo r the ENA de aling with the value of these credits.31 Unlikely at least because there is a time delay between the distribution of the imputation tax benefit and the

cash flow benefit to the ultimate shareholder.


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5.2.3 Risk Free RateOur estima te of the risk free rate is the yield on 10 yea r ma turing Treasury Bonds. The d a taseries from 1883 to 1968 wa s tha t c ollec ted in the Offic er series:

The intention was to use long-term Commonwealth Bond yields

to approximate the behaviour of interest rates. Under generallyaccepted theories of the term structure of interest rates, changes in

these yields will reflect changes in yields generally across the term

structure. Moreover, we would expect the yields on company

debentures to be similarly affected. For the period 1882-1914, yields

were taken from New South Wales government securities traded on

the London capital market (Hall 1963). For the period 1915-1949 the

yields were on Commonwealth Government Securities maturing in

five years or more (see Reserve Bank bulletins). Finally, for the

period 1950-1982, yields were taken from 10-year rebateable

Commonwealth Government Bonds (see Reserve Bank 1982) and from

1982-1987 non-rebateables were used. The reason for switching

between rebateables and non-rebateables was the lack of trading

and/or availability of data on one or other of these security types the

typical difference between the yields of the two types is low, of the

order of 5 per cent of the security's total yield, which implies the

effective tax rate of traders in these securities Is also low,

approximately 5 per cent32.

The risk free p roxy series from Dec em ber 1969 to 2007 was collec ted from the Reserve Bankof A ustralia [ RBA ] w eb site.

The RBA da ta were che cked a ga inst the Office r series whe re it overlapped . Except forone yea r, any differenc es we re minor. Further the da ta were chec ked aga inst the

summ ary da ta in Bra ilsford et al and comfort ga ined tha t the series a re c onsistent . In ourop inion there is no ma terial d ifferenc e in the O fficer series and the series used here.

5.3 Results and ComparisonsA key conclusion from our analysis is that there is not any compelling evidence from thehistorical series that ignores imputation tax benefits that would lead to a reduction in the6% MRP widely used in histo rica l p rice d ete rminat ion hearings. If there was a c hange tha tcould b e supp orted from the evidenc e then it would b e a n inc rease to 7% arising from theinclusion of the return from imputat ion tax bene fits.

Despite examining an historical series from 1883 to 2007, we have placed greatest

em pha sis on the p eriod 1958 to 2007. This follows the work of Brailsford e t a l who ha vecarefully reviewed the market return data prior in the Lamberton series prior to 1958 andargue, amongst other matters, that the market return in this period overstated thedivide nd return comp onent. In essenc e this wa s be cause the divide nd yield wa s ba sedon dividend paying stocks only and was not adjusted to reflect a zero dividend yield onnon d ivide nd p aying stoc ks when a pp lied to the index.

Our work updates the Bra ilsford e t a l work by inc luding 2006 and 2007 da ta and p ote ntiallya more exac t ad justment for the pe rc entage o f divide nds that a re franked .33

32 See fo otnote for ma rket retu rns for sourc e (O ffice r 1989).33 We use the word potentially as we do not fully understand the data sources for the Brailsford et al

adjustments.


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5.3.1 Ma rket Risk Prem ium (MRP)The MRPs we re c a lculated as the d ifferenc e b etw een the historica l ma rket return and theop ening Trea sury bo nd yield. These a re p resente d in Figure 2 along with the a rithmet icaverage o f the series (7.5%).

Figure 2: Marke t risk p remium 1883 - 2007

Ma rke t Exc ess Returns

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

1883

1887

1891

1895

1899

1903

1907

1911

1915

1919

1923

1927

1931

1935

1939

1943

1947

1951

1955

1959

1963

1967

1971

1975

1979

1983

1987

1991

1995

1999

2003

2007

Of note is the considerab le vo lat ility in the histo rica l series. The rang e is from -32% to 54%.Also a pparent from an eyeba ll test is the grea ter volat ility p ost 1929.

Summa ry informa tion is p resented in Table 6. The MRP in this Tab le does not c onta in anad justment for any value that m ight be at tached to imp utation tax bene fits.

Tab le 6: Ave rage MRP ove r inc reasing observation intervals

95% Confidence IntervalPeriod No. Yea rs Average

(%)Standard

Error

Low High Range

1958 2007 50 6.7 3.1 0.6 12.9 12.3

1968 - 2007 40 6.0 3.7 -1.2 132. 14.4

1978 2007 30 7.9 4.0 0.1 15.7 15.6

1988 2007 20 5.8 3.4 -0.9 12.5 13.4

1998 2007 10 8.4 3.4 1.7 15.1 13.5

1883 - 1957 75 8.0 1.4 5.2 10.2 5.5

1958 - 1987 30 7.4 4.8 -2.0 16.7 18.7

1883 2007 125 7.5 1.5 4.5 10.4 5.9

1888 2007 120 7.4 1.6 4.3 10.5 6.1

1898 2007 110 7.5 1.7 4.3 10.8 6.6

1908 2007 100 7.4 1.8 3.8 11.0 7.2

1918 2007 90 7.5 2.0 3.6 11.5 7.9

1928 2007 80 7.0 2.2 2.6 11.4 8.8

1938 2007 70 6.8 2.4 2.0 11.6 9.6

1948 2007 60 7.0 2.8 1.5 12.4 10.9Sourc e: O ffice r, Bloom be rg, RBA


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Tab le 6 show s the a verag e MRP for the c leane st da ta according the Bra ilsford et alresea rch i.e. post 1958, and the same informa tion fo r the p eriod 1883-1957. The a rithm et icaverage for this more recent 50 year period, excluding an imputation tax benefitad justm ent is 6.7%. This num ber is smaller than the 8.0% for the 77 year prior period ,perhaps partially due to the potential overstatement of the dividend yield noted byBra ilsford et a l. The Tab le also shows the a verag e for the p re and p ost imputa tion taxpe riod however little c an be interpreted from this given the high standa rd de viat ions (the

d ifferenc e is not sta tistica lly significa nt) a nd exc lusion of the imp uta tion ta x benefits.

Table 6 a lso d isp lays the 95% confidenc e interval, assuming normality34 in MRPs, assoc iatedwith the average for the d iffering time intervals. Over the entire p eriod it c an b e sta tedwith a 95% deg ree of c onfidenc e that the average fa lls in the range 4.5% to 10.4%. This isa wide range highlighting concern for accuracy of dealing with multiple decimal pointswhen looking at a verages. Note how the range fo r the 95% confidenc e interval gene rallyincreases as the number of observations decreases (see Figure 4 for a graphicrep resenta tion). This me ans the a verag e numb er has de c rea sing reliab ility as the timeperiod red uces. As noted e lsew here (see Sec tion 3.1), there is a trad e off betw eenstatistical reliability from examining the greatest number of observations and concern thatthere may have been some underlying structural change in the required market risk

premium during the p eriod .

5.3.2 Impac t of Imputa tion Tax BenefitsAs noted ab ove , Stoc k Market Accumulation Indexes comp uted in Australia reflect adivide nd yield and a c ap ital ga in yield. They do not c onta in any yield from imputation taxbenefits that may have arisen from the introduction of the imputation tax system in July1987.

Our estimate of the adjustment to the market risk premium to reflect imputation taxbene fits under d ifferent a ssump tions of the va lue of these bene fits is p resente d in Tab le 7.It shows that with imputation tax benefits valued at $1 per dollar, there should be anaddition of 70 basis points over the period 1958 2007 bringing the average MRP to 7.4% (.On the other hand, if imputation tax benefits were valued at $0.50 per dollar, there shouldbe a n add ition o f 34 basis po ints ove r the period 1958 2007 bringing the averag e M RP to7.1%.

Tab le 7: Imp ac t of Imputation on MRP

Period Ma rket Risk Prem ium

= 0 = 0.5 = 1Yea rs Ad j. With Imp Ad j. With Imp

1998 - 2007 10 8.4 0.9 9.3 1.7 10.1

1988 - 2007 20 5.8 0.9 6.7 1.7 7.51978 - 2007 30 7.9 0.6 8.5 1.1 9.1

1968 - 2007 40 6.0 0.4 6.5 0.9 6.91958 - 2007 50 6.7 0.3 7.1 0.7 7.4

1948 - 2007 60 7.0 0.3 7.2 0.6 7.5

1938 - 2007 70 6.8 0.2 7.1 0.5 7.3

1928 - 2007 80 7.0 0.2 7.2 0.4 7.41918 - 2007 90 7.5 0.2 7.7 0.4 7.9

1908 - 2007 100 7.4 0.2 7.6 0.3 7.7

1898 - 2007 110 7.5 0.2 7.7 0.3 7.9

1888 - 2007 120 7.4 0.1 7.6 0.3 7.7

1883 - 2007 125 7.5 0.1 7.6 0.3 7.8

34 This is a usual a ssump tion but one that is likely to b e v iolated and therefore the interpreta tion of the prob ab ility

of the true MRP falling within the rang e has to be treate d w ith a great d ea l of sc ep ticism!


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As noted ea rlier, the p ercenta ge of d ividends franked wa s estimated in two wa ys. In thefirst c ase, data p ub lished by the Australian Tax Office [ ATO ] on to ta l d ividends paid ,broken in to franked and unfranked provided an estimate for each year from 1993 to200735. This va ried from ye ar to yea r as is ev ident from Figure 3. Also inc lude d in Figure 3 isthe weighted percentage of franked dividends for companies included in the index from2001 2007.

Figure 3: Mix of franked and unfranked dividends, all com pa nies

Percent Franked Dividen ds

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1993

94

1994

95

1995

96

1996

97

1997

98

1998

99

1999

200

0

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

2006

-07

ATO Data Bloomberg data

Sourc e: ATO Table 6, Bloom be rg

According to ATO d ata 36, rec ent franked divide nds in the last 3 yea rs ab ove have be en inthe orde r of 90% of to ta l dividend s. This is well above the ove rall average of 66% for theperiod fo r which da ta is ava ilable. This ove rall averag e pe rcentage was assumed to

apply in the yea rs 1988 to 1992 and 2006 to 2007. These were the yea rs for which taxsta tistics are not ava ilab le. The ac tua l percenta ge s and d ividend yields we re used fo rother years to a rrive a t a (time and divide nd yield) we ighted ad justment to the MRP.

The ATO sta tistics c ove r a rang e o f com panies tha t a re b roa der than tho se included in theAll Ordinaries Inde x. Conseq uently there m ay b e a differenc e b etween this number andthat a pp lic ab le to the inde x. We note Hatha wa y (2004) estimates the pe rcenta ge o fd ividend s franked to be 70% for 1988 2004 based in a c ap italisat ion we ighting o f his datafile of listed c om panies. We also note tha t Brailsford e t al use 70% to rep resent thepercentage of dividends that are franked and apply it for the post imputation taxintrod uc tion p eriod 37. Both these a re above the 66% averag e from the tax sta tistics buta re c onsistent with our estima te fo r the index ove r the pe riod 2000/01 to 2006/7 as noted in

our sec ond a pp roa ch below.

In our second approach to estimating the adjustment to the market index to reflect avalue to imputation tax benefits, the franked dividend percentage for each stock in theindex for each year was extracted from Bloomberg data and weighted by the stockswe ight in the index. This be tte r a ligns the franking ta x c red it with the d ividend yield in theindex. Bloomberg histo ry wa s only ac cessible ba ck to 2001.

35 We note that the ATO p ublished numb ers c an c hange from publication to p ublica tion36 Comp any Tab le 7 www .ato.gov.au/c orporate

37 The p ap er says For the p eriod 1998-2005, we use the (weighte d) a verag e imp utation c redit yield on the ASX

All Ordinaries Inde x for the 12 months ending Dec emb er of ea c h yea r, as source d from the A ustralian Taxa tion

Office.


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The c om para tive outc om e with the ATO sta tistics is p resented in Figure 2. There wa s quitea bit of difference in the year by year statistics yet the overall average percentage forcom mon years for franked sta tistic wa s similar at 72% for both.

Franking of d ividend s wa s largely b inary with c irca 47 - 50% in numb er being fully frankedand 40 43% being e ither non d ividend pa ying or unfranked ove r 2001 2007. As noted ,the c ap italisation weighted ave rag e was c irca 72%.

Also of interest was that the capitalisation weighted percentage of non dividend payingstoc k was, on ave rage , 6% ove r the 7 yea r period .

If imputation tax benefits are fully valued then the adjustment to the market risk premiumwo uld be , on a verag e, 170 basis po ints using our sec ond approa ch ab ove . This is belowthe Brailsford et al estimate of 190 basis points but above the Hathaway estimate of 105ba sis po ints. The latter differenc e c an b e explained by a differenc e in divide nd yield Hathaway posited 3.5% as the dividend yield whereas we used the yield derived from thedifferenc e be tween the ac cumulation and p rice indexes for ea ch year. This wa s greate rtha n 3.5% on averag e. We haven t fully explored the d ifferenc e to the Bra ilsford numb ersa t this time.


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6. Further Issues in Estimating an MRP6.1 IntroductionA num be r of me asurem ent issues assoc iated with estima ting the MRP we re ad dressed priorto p resenting a nd d iscussing the histo rica l series of MRP. In this sec tion we use the da ta toaddress some additional issues and to illustrate the points made earlier about

measureme nt challenge s and ab out formulat ing a view of an a pp rop riate forward lookingMRP.

We reiterate tha t our objec tive is to fo rm a view a bout the MRP for the CAPM. The MRPshould be what investors expect from an investment with a beta of 1 i.e. it is forwardlooking ho wever we a re using the pa st to guide a view ab out this forwa rd looking MRP.

By wa y of o rga nising our comm entary we refer to Dimson, Ma rsh and Sta unton (2000).These authors p resent three reasons why it ma y ma ke sense to loo k be yond histo rica l da tato form a v iew ab out the M RP to use in a CAPM b ased cost of c ap ita l. Parap hrased ,t

market risk premium_2008

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