Thursday, April 5, 2012

Taxes and Dividend Strategy

Our last post covered Apple Computer’s dividend and share buyback announcement from a “those folks know more than we do about the company” perspective, a state of affairs some like to call “asymmetrical information”.
We did this because we wanted to explore how information differences “change the game” when compared to the theoretical perfect capital market world.
Today we examine another common perfect-capital-market-assumption “violation” and explore what this means in the context of distributing funds to investors.

Only Two Things are Certain in Life
Assumption #2 from our list of Perfect Capital Market Assumptions is “Absence of Taxes”. If ever there was an assumption in theory that does not hold true in reality this is it - taxes are everywhere!
The company’s choice to either distribute funds to shareholders or retain funds to make further investments has implications for shareholders from a tax perspective. Dividends are usually considered “Income” to an investor, while funds received for selling shares is considered “Capital Gains or Losses”. [Note that these are terms I am using in a very general sense and am not providing tax advice of any kind]

Do Taxes Change our Conclusion?
Figure A
So let’s add the new wrinkle of taxes to our example from the last post, where we established that investors are indifferent to fund distribution or retention by the firm under the perfect capital market assumptions.
Figure B
Figure A shows the original results from our last post, where we are considering the value of a firm that earns ²10 per year in cash, is expected to earn that in perpetuity, with a cost of capital of 10% under a full payout scenario and a full retention scenario. Each scenario is worth ²110 to the investor, as shown in the Results box (sum of the Discount Factor at 10% line and the Total Proceeds to Investor line).
Figure B shows the same pattern with a tax rate of 25% for both dividends and capital gains. Note that the investment values, while now somewhat lower, are still the same for each scenario.
This leads us to conclude that even with the addition of taxes, so long as the tax rate is the same between the different categories the original thesis still holds true: investors will be indifferent to the full payout or full retention scenarios.
Figure C
What about when tax rates are different? As you may have already suspected, this does change our conclusion. Figure C shows the results if Capital Gains taxes (30%) are higher than taxes on Income (20%), and Figure D shows the results if taxes on Income (30%) are higher than on Capital Gains (20%). Investors subject to varying tax rates will value the dividend or re-investment strategies differently, with the policy that coincides with their lower tax alternative more highly valued.
Figure D

Research is Mixed
Prior to 2003, US taxpayers faced different rates for dividends compared to capital gains. In 2003, the US enacted tax legislation that cut the tax rate on dividends to be equivalent to capital gains.
Based on our calculations above, this should have made the dividend payout strategy more attractive than before and therefore we should have seen a general increase in dividends. The research on this is mixed, however. A review of many of the studies was performed as part of an analysis conducted by the Federal Reserve.
Some studies suggested there was an impact from the tax rate change, and others did not.  Things in life are not so simple as in theory. The biggest problem is the fact that there is not a way to conduct these studies in a pure experimental fashion.
A normal scientific experiment is set up so that any difference between the “control” group and the “experimental” group can only be attributed to the factor under study, because all other factors are kept constant between the two groups.
In the case of the dividend studies, this cannot be accomplished. For example, the tax cuts occurred during a time when the economy was growing. So were dividend increases due to the tax cut or because companies were doing better and had more excess cash to distribute? There is no easy way to tell.

Taxes have Valuation Implications
From the perspective of our organizations, taxes do have an impact on the valuation, as our example earlier illustrates. If we go from different treatment of income and capital gains to the same treatment (compare Figure C or D to Figure B), one strategy would be valued higher by ²2.40 and the other group would be valued lower by ²2.40.
Given that Apple enacted a dividend, it is in essence taking a view on whether the 2003 tax rate for dividends will be extended. If this tax rate is not extended, then the stock’s valuation should evidence some “adjustment” for the higher tax rates. This would not have occurred if they implemented a one-time special dividend instead.
Taxes and valuation are intertwined at a more primitive level as well. Many firms use the Capital Asset Pricing Model (in one of its many permutations) to assess what their cost of capital is. A major component of this calculation is determining how the price of a security changes given a change in the market (the relationship of the changes is called “beta”).
However, as we have seen, the level of taxation affects the valuation of a security. So if the market moves 10% and our stock under consideration moves 12% (a beta of 1.2), is the tax rate on the market investors the same tax rate as those of our security? Maybe…maybe not.
Say that investors in the market are 70% in the highest tax bracket and 30% in the lowest. If our stock has an investor mix that is 50%-50% in each, then the tax rate differential is part of the difference in returns, and not due to “beta”. We should thus adjust accordingly to arrive at our “true” cost of capital.
However, in the real world we do not know our investors tax brackets and cannot make such an analytical assessment. Perhaps we could if we conducted a really intensive survey, but this would likely be very costly and the results might still be somewhat tentative. So suffice it to say that tax code impacts our cost of capital in ways we can only approximate.

Key Takeaways
Taxes impact our financial strategy in a number of ways. First, tax rate differences between capital gains and income can determine whether it is more optimal for us to retain funds for reinvestment or distribute them to shareholders. Taxes can also impact the valuation of our company, independently and in relation to the market. Finally, it is unclear as to whether establishing an earnings distribution policy or an earnings re-investment policy is optimal from a tax standpoint, based on research performed to date. Due to this uncertainty, taxes do not appear to be a driving force behind dividend policy.
·         What is your firm’s earnings distribution and earnings re-investment priorities? Are taxes taken into consideration when these are being established?
·         How can investor’s tax preferences be discovered?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!


  1. Great analysis here Dave. Dividends are near and dear to my heart and an important part of my "widows and orphans" portfolio. Any thoughts on how the tax benefit of qualified dividends impacts your analysis?

    1. Tyler,

      Most of the studies mentioned in the post came about because of the qualified dividend status that becaome part of the US tax code in 2003.

      In essence, this created a situation where dividends were on par with capital gains, making the two extreme scenarios we look at in the post (full payout and full retention) equivalent from an investor taxation standpoint.

      Thanks for reading and taking the time to add to the discussion. Good luck with the "widows and orphans" portfolio!

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