LECTUREPEDIA - Ajarn Paul Tanongpol, J.D.; M.B.A.;B.A.; CBEST
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IV.

TAX AND DIVIDEND POLICY

There are two alternatives available for the firm to raise capital: issue security or bond. If we are to assume that the capital market is perfect and that there are two types of income, namely ordinary income and income from capital gain. Under such circumstances, the investor will have to deal with two types of income tax. One type of income tax is one which is taxed according to the level of income. This is known as marginal tax. In most country, marginal income tax implies that the income tax structure is a progressive rate system. Taxpayers pay their taxes according to the income level. The second type of income tax liability is capital gains tax. Capital gains tax is taxed at a fixed rate. For purposes of or discussion, we shall adopt the following definitions:

         = tax rate;

        = marginal tax rate on ordinary income;

       = capital gains tax on the gain in value of securities;

Therefore,

                                                                                       [4.a]

Similarly, if the income stream of the capital gain is the market value of the income stream for the capital gain in security, then  . If the income stream of the marginal investor is not subject to personal income tax, then:

                                                        [4.b]

The capital gains tax becomes:

                                                                                      [4.c]

The assumption in [4.a-c] is that the income in  is not subject to personal income tax. The income received from  is only subject to capital gains tax. The capital gain tax is .

            In the following discussion, we adopt the following definitions:

    = current value of the shares owned by shareholder (cum-dividend);

       = value of old shares that go to ex-dividend;

      = newly issued shares;

        = changes in value;

       = capital gain tax in value of securities; and

      = dividend received from securities.

Cum-dividend shares referred to the newly issued or acquired security which will not be paid dividend in the current operating quarter. Ex-dividend referred to the old share which goes ex-dividend, meaning the old share which will receive dividends in the current operating quarter. The current value of shares owned by shareholders or cum-dividend can be expressed as:

By simplification, we have:

                                                                       [4.1]

            It becomes clear from equation [4.1] that the objective of the shareholder is to maximize the current share owned. Since the current share owned does not go ex­-dividend at the time of acquisition, the quantity  because there is no dividend paid. Similarly, unless the investor has existing shares, since there is no old share that will go to ex-dividend, the quantity is also , thus making . The implication is clear; the objective o the investor is to maximize wealth. Wealth maximization requires (i) the security must pay dividend; and (ii) it not advisable to buy security after it has gone ex-dividend. To buy the security when  would mean that the purchase is for purposes of speculation. The speculation does not depend on the real earning capacity of the security because no dividend will be paid. The statement does not mean that the security is worthless, but it means that the security income potential from dividend payment in the short-run. The dividend will be paid after it has gone to ex­-dividend. In summary, the security in cum-dividend does not worth as much as the security that will soon go to ex-dividend. For this reason, it is expected that the price of the security will rise before the security goes to ex-dividend.

            The argument  stated above seems to make capital gains tax irrelevant. However, in fact, capital gains tax  is relevant because during the time just before the security goes ex-dividend, investors would speculate on the value of the security and causes the price of the security to rise. During this speculation period,  there will be by and sell order in the capital market. Investors who sell the security during the rising time will experience capital gains and, therefore, must be liable for capital gains tax: . The speculation comes from the differences in valuation between buyers and sellers. For the shareholders who had received dividends from ex-dividend securities, they would want to get rid of the securities. For investors who are looking for income securities, they would want to buy the securities during the cum­-dividend period. The speculation for cum-buyer is that the dividend will be declared again. Thus, . The change in the value of the security between  can be written as:

                                                                          [4.2]

            For both the firm and investor, the best policy is the policy that would maximize the value of  in both the dividends portion () and the value of the old shares (). As the firm operates and needs additional capital to expand its operation, new shares will be issue. The new shares are designated as . Therefore, the total value of all shares, new and old, is written as:

By substitution, we have:

, the change in value of old share will go ex-dividend is:

                                                                                              [4.3]

By further substitution, the change in value becomes:

                                                                [4.4]

            Note that dividend is treated as an ordinary income. It is taxed as an ordinary income at the rate of , not . The changes in the value of the securities, on the other hand, is treated as capital gain or capital loss; thus, the net capital gain is . The tax implication in investment in securities comprises of both marginal tax and capital gains tax.

            The statement  needs to be qualified. During the period of cum-dividend, any changes in the value of the security will be treated an ordinary change; that is, the gain will not be classified as capital gain, but it will be treated as ordinary income. This period is set by the SEC regulation to equal to 60 days. If the security is held for less than 60 days, the gain will be classified an ordinary income; thus, < 60 days.

            We are still concerned by the valuation of the security. To investors, the question remains the same: how much is the security worth? The value of the stock is the after-tax dividends income and after-tax capital gain from selling the security. This statement is written as:

                                                                         [4.5]

            Equation [4.5] is the general condition of the valuation of the security. If the firm issues bonds, the value of the security will be affected because the firm would have to pay for the bond interest. As the result, the money that the firm has to pay dividends will be affected. If there is a bond issuance, the valuation  will be change. This change is designated as  after the issuance of the bond .

                                                                  [4.6]

The issuance of bonds will create a net cash drain from the firm: . Where  is the interest payment on the bond. This debt service amount is tax deductible .

            Assuming that there are no additional capital inflow into the firm, there are two options available to the firm to meet its dent service requirements. Either firm reduces dividends payment by , or by issuing new stocks. If the firm issues new stock, the value of the stock will be diluted in the amount ; there is a corresponding reduction in capital gains equal to . If the profit from operations does not exceeds the debt service requirements, the dividend will be reduced to zero and used the dividends to pay for debt service. Under these circumstances, the capital gain becomes:  and .

            The effect on the security value with the reduced dividend becomes:

                                                                     [4.7]

The value of dividends payment as the result of issuing bonds is equal to the value of debt service requirement. If there is no dividends or that the dividends is negative, the value of the stock will most likely fall.

            If the dividend is zero, the capital gain is negative or reduced:  and . The effect on the security value with the reduced capital gain becomes:

, or

                                                                    [4.8]

            The assumptions in equations [4.6] to [4.7] are extreme. It was assumed that all dividends are cut in order for the firm to service its debt; as the result, there is not capital gain. In a less extreme case, both dividend and capital gain will be reduced, not eliminated. In such a situation, the value of the old shares will be expressed as the weighted average, thus:

                                                                            [4.9]

where  and . If the firm is expected to pay dividend,  will be close to 1.0. A firm that would not pay dividend, the value of  will be close to 1.0. The tax implications are show below:

                                                      [4.10]

The value of interest payment by the firm  is equal to the debt issued by the firm,  which is:

, or

                                                                                      [4.11]

The tax rate used in equation [4.11] is the tax rate for ordinary income because the interest payment or debt service on debt is deducted against ordinary income, not capital gain. We can now substitute back into equation [4.8] and the change in value of the old security becomes:

, or

                                                           [4.12]

            The debt issued by the firm will affect the value of the firm’s stock. The more bond the firm issue, the less the value of its stock. The tax implications in the value of the firm’s stock, as shown in equation [4.12],  tell us that the valuation of the firm stock takes capital gain tax and ordinary income tax into consideration when investors assess the firm’s stock.

            If the firm issues bond, the corpus of the bond is the principal of the debt which the firm must ultimately pay when the bond matures. There are two components to the bond liability: interest payment and the bond principal. When the principal is introduced into the equation, the following changes occur:

                                                    [4.13]

The value of the stock with changes in stock price or capital gains becomes:

                                                    [4.14]

The above conditions will also affect the changes in the value o the bond. The bond valuation becomes:

                                                                    [4.15]

The tax implication of equation [4.15] tells us that the changes in bond value produce ordinary income. The tax rate use is marginal income tax rate. Equation [4.15] also tells that the principal and interest payment by the firm is treated as deductible expenses. The principal amount  is deducted as an actual expense. The interest payment  is can be deducted to the extent adjusted by the corporate tax rate for ordinary income.

            The payment for the bond principal may not occur all at once. Certain principal will be paid at time 0, others will be paid at other time. Assume that this proportional bond principal payment equals to p, the payment of principal will also reduces the interest payment or debt service requirements for the bond; thus: . The change in value for interest payment becomes

                                                                              [4.16]

            At this point, we rewrite equation [4.12] as:

                                         [4.17]

With equation [4.17], we conclude that the change in value of the firm’s security or stock is equal to the changes in bond value adjusted by the corporate tax rate multiplied by the portion of the principal of outstanding debt paid.

Last modified: 11/11/08