School of Accounting
RESEARCH SEMINAR
SESSION 1, 2003.
Simultaneous estimations
of the implied value of
franked dividends, cost of equity
and growth rates
using a modified residual
income valuation model.
presented by
Julian Yeo
University of Melbourne
Date: Friday 11
th
April
Time: 3:30 to 5:00 p.m.
Where:
Webster 256
Simultaneous Estimations of
the Implied Value of Franked Dividends,
Cost of Equity, and Growth Rates using a
Modified Residual Income Valuation Model*
Julian Yeo
jyeo@unimelb.edu.au
Department of Accounting and Business Information Systems, The University of
Melbourne, Victoria 3010, Australia
Even though it has been more than a decade since the imputation tax system was
introduced in 1987 in Australia, the appropriate treatments for imputation tax credits for
security valuation purposes remain contentious. By using a novel approach that builds
upon the residual income valuation model, this study addresses the following two
questions: What is the market value of franked dividends?; What is the cost of equity in
the presence of imputation tax credits? These issues are of broad interests to any country
with some form of imputation tax system in place.
An estimation procedure is developed to simultaneously estimate the cost of
equity, the value of franked dividends, and growth rates in tax-adjusted residual income
for a portfolio of firms. Using a set of firms followed by I/B/E/S between 1993 and 1999,
the results show that the market value of a dollar of franked dividend is around $1.20
from 1993 to 1997 and slightly lower (around $1.15) for 1998 and 1999. The value of
franked dividends varies across industries, with a dollar of franked dividends worth no
more than a dollar of cash dividend in the finance sector for the year 1999 to $1.37 in the
building/engineering/manufacturing sector for the year 1996. The cost of equity
estimates (discount rates) applied to payoffs that exclude imputation tax credits range
from 7.37% to 9.95% over the sample period, while the cost of equity estimates applied to
payoffs that adjusted for imputation tax credits range between 7.95% and 10.93%.
Further analyses show that firms align their tax paying patterns with their tax clienteles,
portfolio of firms with higher average effective tax rates have a higher market value of
franked dividends compared to firms with lower average effective tax rates.
Preliminary draft (February 2003), please do not cite or quote without permission.
* This is based on my PhD dissertation. I am indebted to my supervisors - Peter Easton and Nasser Spear.
This paper has also benefited from numerous discussions with Greg Clinch, Kevin Davis, and David
Robinson, and Stephen Penman. I thank workshop participants at the 2002 Capital Markets Research in
Accounting Symposium at the University of Melbourne and the 2003 Summer Research School in
Accounting at UTS.
“
Double taxation is bad for our economy. Double taxation is wrong.”
“It’s fair to tax a company’s profit. It’s not fair to double-tax by taxing the shareholder
on the same profits
.”
George W. Bush; January 7, 2003
1
1. Introduction
Most countries operate with a full or partial integrated tax system for corporate
tax and personal income tax.
2
A fully integrated corporate and personal tax system, in a
form of an imputation tax system, was introduced in Australia in 1987. Under the
imputation tax system, the receipt of imputation tax credits (that are attached to cash
dividends) entitles investors to a tax rebate to the extent that corporate taxes have already
been paid on dividends. Dividends that are attached with franking credits are commonly
referred to as franked dividends.
Ever since the introduction of the imputation tax system in Australia, there is no
unanimous agreement amongst academics and practitioners on the appropriate treatments
of imputation tax credits on security pricing. What is the market value of a dollar of
franked dividends? What is the appropriate cost of equity estimate to be applied for
valuation purposes in the presence of imputation tax credits? Answers to the above
questions remain divergent and inconclusive. The aim of this study is to address the two
questions using a novel approach that builds upon the residual income valuation model.
The study also aims to provide a way to conceptualize the elationship between
imputation taxes, entity-level accounting variables, and market measures of firm values.
These issues are of broad interests to countries with some forms of imputation tax
systems in place and countries that are in the process of intro ducing an integrated
corporate and personal tax system (i.e., in the case of the US).
3
1
See George Bush’s growth and job plan to strengthen America’s economy on January 7, 2003.
http://www.whitehouse.gov/news/releases/2003/01/print/20030107-5.html
2
Australia, Germany (up to October 2000), Italy, and New Zealand have full imputation tax
systems where all of the corporate tax can be offset against personal tax obligations. Many other countries
such as Canada, France, Spain, and the United Kingdom have partial imputation tax systems.
3
The centerpiece of Bush’s economic plan in January 2003 is the elimination of the double
taxations of dividends which will cost $US364 billion over the next 10 years.
2
Imputation tax credits are created when companies pay taxes on profits. These
credits are usually transferred to investors when companies opt to pay franked dividends.
4
Depending on the tax status of investors, imputation tax credits allow certain recipients to
offset their personal tax liability against the amount of tax that has been paid on
dividends by the company.
5
Investors are unlikely to value imputation tax credits that
they cannot use. Since some recipients are unable to utilize credits that are distributed,
the extent to which imputation tax credits are impounded into the company’s share price
(i.e., the value of imputation tax credits) depends on the amount of imputation tax credits
that will be eventually created, distributed, and utilized.
6
The knowledge of the value of imputation tax credits has direct application to
firms’ capital budgeting exercises, optimal capital structures, and dividend distribution
policies. Under an imputation tax system, a portion of taxes paid at the corporate level is
often thought of as a pre-collection of personal tax (Officer, 1994). Effectively, the
amount of company tax will be lowered by the amount of imputation tax credits
distributed and utilized. The tax benefits of imputation tax credits need to be accounted
for in the calculation of payoffs in capital budgeting decisions.
7
It has also been
suggested that the value of the tax shield on debt depends on the amount of imputation
tax credits that shareholders can utilize (Howard and Brown, 1992; Twite, 2001).
8
4
Each dollar of fully franked dividends consists of two components: a cash dividend and an
imputation credit. The value of franked dividends is the joint value of cash dividends and imputation tax
credits.
5
The receipt of imputation tax credits affects the personal tax liability of investors that qualify as
Australian residents for tax purposes. The imputation tax system aims to eliminate the double taxation of
dividends that occurs both at the corporate tax level (dividends are paid out of after tax earnings) and
personal tax level for Australian residents.
6
These mark the three milestones in the life of imputation tax credits first described in Hathaway
and Officer (2001).
7
If the adjustments for imputation tax credits were to be made in the discount rate, the firm’s
weighted average cost of capital (WACC) would depend on the value attached to imputation tax credits by
marginal investors (Officer, 1994).
8
Howard and Brown (1992) argue that for shareholders who can utilize imputation tax credits,
companies should not minimize company tax but rather maximize pre-tax profits, pay the applicable tax
and pass the imputation tax credits to shareholders. Twite (2001) examines the changes in capital structure
around the introduction of the dividend imputation tax system in Australia and finds evidence supporting
firm’s incentives to reduce the level of debt financing and increase the level of external equity financing in
the presence of imputation tax credits. These incentives are found to vary across firms depending on the
firms’ effective corporate tax rate. The benefits of a tax shield must thus be weighed against the value of
imputation tax credits that shareholders can access. Also, see Kemsley and Nissim (2001) and Kemsley
and Williams (2001) for discussion on how dividend tax capitalization is related to the value of the debt-tax
shield on an after personal tax basis.
3
Lastly, the decision to retain or distribute dividends rests on whether investors are able to
utilize the imputation tax credits. It follows that knowing the value of imputation tax
credits assists in fine-tuning dividend distribution decisions.
9
Even though it has been more than a decade since the imputation tax system was
introduced in July 1987 in Australia, there is still no consensus on the market value of a
dollar of franked dividends.
10
Most empirical studies so far have relied on drop-off
events (i.e., the drop-off in share price when a share goes ex-dividend) across different
time periods and tax regimes to examine the value of franked dividends and imputation
tax credits (Brown and Clarke, 1993; Bruckner, Dews, and White, 1994; Partington and
Walker, 1999; Hathaway and Officer, 2001).
11
It is widely recognized that the estimates
of franked dividends (and imputation credits) via drop-off ratios exhibit considerable
variations. In addition, the ex-dividend price change may be confounded by other
unrelated events.
12
For example, short-term arbitrage trading activities around the ex-
dividend dates may cause the prices used in inferring the value of franked dividends to
differ from the equilibrium price of all future franking credits incorporated in the market
prices of equity.
13
Recent studies deviates from drop-off events by exploiting trading arrangements
and certain derivative securities that are unique to the Australian retail market (Cannavan,
Finn, and Gray, 2000; Chu and Partington, 2001; Twite and Wood, 2002) to infer the
9
A good example is Wesfarmers, Inc as cited in Harris, Hubbard and Kemsley (1999). In order to
decide whether franked dividends should be distributed, Wesfarmers surveyed its shareholders’ ability to
access the imputation tax credits. Wesfarmers found that the weighted-average shareholder tax rate was
less than half of the corporate tax rate and created a dividend reinvestment plan to pass on the benefits of
imputation tax credits.
10
It is common in the extant literature to focus on the value of a dollar of imputation tax credits.
The inference of the value of imputation tax credits is conditional on the value of cash dividends.
11
Also, see studies in other countries that focus on ex-dividend day. For example, Germany,
McDonald (2001); France, Alphonse (1999); UK, Lasfer (1995); Italy, Michaely and Murgia (1995).
12
Drop-off calculation from non-consecutive closing price data may be influenced by extraneous
information (Hathaway and Officer, 1994). Walker and Partington (1999) control for this by focusing on a
sample of firms that are permitted to trade on a cum-dividend basis during the ex-dividend period. For the
first time, researchers are able to show that the value of fully franked dividends has a value significantly
greater than $1.00. Nevertheless, their study still doesn’t overcome the noise problems associated with the
drop off event windows.
13
The presence of microstructure effects may also confound the results of these studies. Frank and
Ragannatahan (1998) show that in the Hong Kong market, the bid-ask spread leads to an ex-dividend price
drop-off that is smaller than the dividend amount even though there is no tax on dividends or capital gains
tax. Bali and Hite (1998) in the US argue that dividends are continuous while prices are constrained to
discrete tick multiples, which explains the drop-off to be less than 1. Also, see Shaw (1991) for other non-
tax factors influencing the ex-dividend day price movements.
4