EFN507 Chap.8 Dividend Imputation and the Cost of Capital
Dividend Imputation and the Cost of Capital
Company tax that is really personal tax
Week 6 adapts the cost of capital to Australia's dividend imputation system. Under a classical system profit is taxed in the company and again in the shareholder's hands; under imputation the company tax attached to a franked dividend is credited against the shareholder's personal tax, so for a resident investor part of company tax is a prepayment of personal tax.
Officer (1994) measures that part with gamma, the value of the credits.
Four definitions, four rates
Officer writes after-company-tax cash flow in four ways, from the standard after-tax flow to the classical flow with the value of credits added back, and each has its own WACC; paired correctly, all give the same value.
Dividend drop-off studies suggest a credit is worth less than its face value, and survey evidence shows many Australian firms simply set gamma to zero and use NPV with a firm-level WACC built from the CAPM.
What this chapter covers
- 01
Classical versus imputation taxation of company profit
- 02
Franking credits as a prepayment of personal tax
- 03
Gamma: a market value versus a simple proportion
- 04
Officer's four cash flow definitions and their WACCs
- 05
Dividend drop-off evidence on the value of credits
- 06
Survey evidence on Australian capital budgeting practice
Worked example · free
Two layers of tax or one
- +1Company tax is 0.30 × 200 = $60, leaving a $140 cash dividend in both systems.
- +1Classical: personal tax is 0.37 × 140 = $51.80, so the shareholder keeps $88.20.
- +1Imputation: tax on the grossed-up $200 is $74, less the $60 credit, so $14 more is paid.
- +1The shareholder keeps 140 − 14 = $126, and total tax equals the 37% personal rate on $200.
Key terms
- Dividend imputation
- A tax system in which company tax paid on distributed profit is credited to shareholders against their personal tax.
- Classical tax system
- A system in which company profit is taxed in the company and again as dividends in shareholders' hands.
- Dividend drop-off
- The fall in a share price when it goes ex-dividend, used to infer the value of dividends and credits.
- Grossed-up dividend
- The cash dividend plus its attached franking credit, the amount a resident shareholder declares as income.
Dividend Imputation and the Cost of Capital FAQ
Why does imputation change the cost of capital?
Part of company tax becomes a prepayment of personal tax, so shareholders receive more than the after-tax cash dividend. Valuation must recognise those credits either in the cash flows or in the discount rate, and the WACC formulas change to match.
What exactly is gamma?
Officer defines it as the value of the personal tax credits: the proportion of company tax that will be rebated against personal tax and is therefore personal tax collected at company level. A market value must be estimated, unlike a simple distribution ratio.
Which of Officer's definitions should I use?
Any definition works if it is paired with its own WACC; the lecture notes only one or two make real economic sense. In an exam, state the definition and the rate together, and check that the required return on equity includes the value of the credits.
What do dividend drop-off studies show?
Share prices fall on ex-dividend days by roughly the cash dividend plus some value for the credit. The combined effect is close to one dollar for a fully franked dollar, but the credit alone appears worth less than face value.
Why do many firms ignore imputation?
Survey respondents say it is hard to set one credit value for all investors, that credits are irrelevant to overseas shareholders, that markets already reflect them, or that the effect is small. Ignoring them is equivalent to setting gamma to zero.
Does imputation make debt more or less attractive?
Less. Under imputation the shareholder would receive a credit for company tax anyway, so the extra tax saved by paying interest instead of dividends is smaller. The effective company tax rate falls to the statutory rate times one minus gamma.
Exam move
Value one perpetual firm under all four of Officer's definitions and confirm the values agree, then set gamma to zero and show the formulas collapse to the classical WACC.
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