Topic 7

Capital Structure
&
Dividend Imputation
 Capital Structure
Part 1. Capital Structure
Capital Structure
 The combination of debt and equity used by a firm to finance the investment in
real assets.
 Items found on the right-hand side of the Balance Sheet – Liabilities (debt) &
Proprietorship (equity)
 Established by the financing decision of the firm.
 Summarised by the debt/equity ratio.
 Capital Structure
Optimal Capital Structure
 The combination of debt and equity that minimises WACC such that the value
of the firm is maximised.
 Is there such a combination?
 This topic is concerned with the issue of whether there exists an “Optimal
Capital Structure”.

Optimal Capital Structure And Financial Leverage

 In order to address the issue of an optimal capital structure one needs to first
examine the effect on equity holders of introducing “Financial Leverage” into
the firm’s capital structure.
 Financial Leverage refers to the extent to which a firm relies on debt financing.
 Capital Structure
Firm’s Cash-Flows
REVENUE

less
equals NET OPERATING INCOME
Fixed operating costs
Variable operating costs [NOI]

less

NET INCOME equals

[NI] Interest
 Capital Structure
Effect of Capital Structure On Shareholders
Question - What happens to shareholders’ return when leverage
(debt) is introduced?
Example
 Assume there are three identical firms, a , b and c.
 Identical in all respects apart from the way in which each firm is financed.
 We are initially neglecting the effects of corporate taxation.
 In each case the firm has total assets of $400,000, but the mix of debt
and equity used to finance these assets differs.
 We assume the return each firm can earn on its assets is 15%.
 Therefore Net Operating Income (NOI) of all three firms is the same at
$60,000
 The firms that use debt pay 10% interest.

Slide 5
   (a) (b) (c)
All equity 50% debt 75% debt
$ 50% equity 25 % equity

Equity 400,000 200,000 100,000

Debt   200,000 300,000

Total Assets 400,000 400,000 400,000

Debt/Equity ratio 0 1:1 3:1

Net operating Income 60,000 60,000 60,000

Interest (at 10%)   20,000 30,000

Net Income 60,000 40,000 30,000

Return on Assets 15% 15% 15%

(i.e. 60,000/400,000) (i.e. 60,000/400,000) (i.e. 60,000/400,000)

Available Return on Equity 15% 20% 30%

(i.e. 60,000/400,000) (i.e. 40,000/200,000) (i.e.30,000/100,000)
 Capital Structure
Effect of Capital Structure On Shareholders
Question – What happens to shareholders’ return when leverage (debt)
is introduced?
Example (cont.)
 What happens to the available return to equity holders as result of the return
earned on the firm’s assets decreasing?
 Initially the return on the firm’s assets of $400,000 was 15% giving a NOI of
$60,000. We now assume the return on assets falls to 9% giving a NOI of
$36,000.
 It will be shown the greater is the D/E ratio the greater the drop in the
available rate of return to equity holders.

Slide 7
   (a) (b) (c)
All equity 50% debt 75% debt
$ 50% equity 25 % equity

Equity 400,000 200,000 100,000

Debt   200,000 300,000

Total Assets 400,000 400,000 400,000

Debt/Equity ratio 0 1:1 3:1

Net operating Income 36,000 36,000 36,000

Interest (at 10%)   20,000 30,000

Net Income 36,000 16,000 6,000

Return on Assets 9% 9% 9%
(i.e. 36,000/400,000) (i.e. 36,000/400,000 (i.e. 36,000/400,000

Available Return on Equity 9% 8% 6%

(i.e. 36,000/400,000) ( 16,000/200,000) (i.e. 6,000/100,000)

Change in available return on equity -40% -60% -80%

(i.e. (9% - 15%)/15%) (i.e. (8% - 20%)/20%) (i.e. (6% - 30%)/30%)
 Capital Structure
 The table below shows the greater the debt to equity ratio the greater the change in the available return to
equity holders as a result of a change in the level of Net Operating Income (NOI)
(note: we are assuming, again, total assets is $400,000 and the interest rate on debt is 10% p.a.)
Different levels of NOI ($000)
0 20 40 60 80
Financing package Return on equity
(a) All equity 0% 5% 10% 15% 20%
(b) 50% debt, 50% equity -10% 0% 10% 20% 30%
(c) 75% debt, 25% equity -30% -10% 10% 30% 50%

e.g. 1. NOI = $0: a) All equity ($400,000) ($0 debt) - interest expense = $0; NI = $0 - $0 = $0 ;
RoE = $0/$400,000 = 0%;
c) 75% debt ($300,000) & 25% equity ($100,000) - interest expense = $30,000;
NI = $0 - $30,000 = -$30,000; RoE = -$30,000/$100,000 = -30%;

e.g. 2. NOI = $80,000: a) All equity ($400,000) ($0 debt) – interest expense = $0;
NI = $80,000 - $0 = $80,000; RoE = $80,000/$400,000 = 20%;
c) 75% debt ($300,000) & 25% equity ($100,000) – interest expense =
$30,000; NI = $80,000 - $30,000 = $50,000; RoE = $50,000/$100,000 = 50%

Slide 9
 Capital Structure
Effects of Financial Leverage
The substitution of debt for equity in the capital structure:
1. Increases the available return to equity holders on their investment. This is due to the
firms assets being able to earn a return greater than the cost of debt.
2. Increases the risk (variability of the returns)
associated with the investment. Thus, the greater the range of returns available to
shareholders.

 In summary:
 If a firm has debt in its capital structure, when things are going well for the firm (NOI is
relatively high) shareholders do well – the return on equity (r e) will be relatively high.
 However, If a firm has debt in its capital structure, when things are going badly for the
firm (NOI is relatively low) shareholders do poorly – the return on equity (r e) will be
relatively low.

Next
 Having examined the impact of introducing debt we now turn to examine how it could
impact on the value of the firm through the firm’s Capital Structure

Slide 10
 Capital Structure
REAL ASSETS FINANCIAL ASSETS
GENERATE CLAIMS
A STREAM UPON THE
OF CASH-FLOW
Investing CASH-FLOWS STREAM
Decision Financing
Decision
- inventory - Proprietorship: shares
- machinery -Liabilities: debt
- land & buildings e.g. term loans,
mortgages, debentures
Capital Budgeting Capital Structure
Decision (Topic 4) Decision (Topic 7)

Slide 11
 Capital Structure
Value of the Firm
 The firm may be valued by discounting the future net cash-flows of the firm by
the WACC (r) (which we covered in Topic 6).

n(Re venue  Costs ) t

V
t 1 (1  r ) t
n NOI t
V
t 1 (1  r )
t

Slide 12
 Capital Structure
 We are assuming that the future net cash-flows are the same each year and that
NOI is the same each year. Therefore, the NOI is a perpetuity.

NOI
V = value of the firm.
r
n
 r = WACC =  ri X i
i 1

E D
 WACC  re    rd  
V  V 

Slide 13
 Capital Structure
Value of The Firm
 As NOI increases the value of the firm increases.
 NOI reflects the Investment decisions of the firm.
 As the Weighted Average Cost of Capital decreases the value of the firm
increases.
 WACC reflects the Financing decisions of the firm.
 Question: Is there a minimum value of the WACC which maximises the value of
the firm and how is it achieved?

The BIG Question In Terms of Capital Structure

 Does substitution of cheaper debt finance for equity reduce the overall weighted
average cost of capital and thereby increase the value of the firm?

Slide 14
 Capital Structure
Why Is Debt Cheaper Than Equity?
 Generally, for a given firm, debt financing will be cheaper than equity financing.
 Debt holders have priority over equity holders in their claims on the firm’s cash
flow stream.
 Debt is a contractual claim.
 Dividends are a residual claim.
 Lenders therefore face lower risk than equity investors.
 Consequently, the return required by debt holders (lenders) is less than the
return required by shareholders.
 Capital Structure
The Traditional Approach To Capital Structure
 The traditional approach to capital structure assumes that there is an optimal
capital structure and management can increase the total value of the firm
through the financing method (i.e. by changing the capital structure).

 The traditional approach implies that the cost of capital is dependent on the
capital structure of the firm.

 This was a practical approach without a theoretical basis.

 The determinants of, or path to, the optimal D/E ratio (i.e. to the optimal
capital structure) were never specified (i.e. there was no formal model).
 Capital Structure
Traditional View of The Effect of Leverage
 As the amount of debt increases this initially reduces the WACC (because debt
is cheaper than equity).

 However, the cost of debt is not constant but at some point increases.

 The required rate of return shareholders demand also increases as the level of
debt increases and this offsets the initial reduction in WACC.
(The required return of shareholders increases as the level of debt increases
because as more debt is used the firm becomes riskier)

 Traditional view - there is an optimal capital structure - it is where WACC is at a

minimum and, consequently, the value of the firm is at a maximum.
 Capital Structure
Traditional View: Example of The Effect of Leverage

r (WACC) = rd (D/V) + re (E/V)

0.086 = 0.05(10/100) + 0.090 (90/100)

0.084 = 0.05(25/100) + 0.095 (75/100)

0.075 = 0.05*1(50/100) + 0.10 (50/100)

In this example this would be the optimal capital structure (50% debt, 50% equity) as the
WACC of the firm (r) is at a minimum.
*1
Up to this point as the amount of debt has gone up the cost of debt (rd) has remained constant (at 5%) (while the cost of equity (re) has
risen).

But
0.077 = 0.07*2(90/100) + 0.14 (10/100)
Now WACC has started to rise – too much debt has been taken on.
*2
Notice as debt has gone up to $90 the cost of debt (rd) has now started to rise (from 5% to 7%) (and the cost of equity (re) has
continued to rise).
 Capital Structure
Modigliani & Miller (M & M)
 M & M questioned the traditional view of capital structure.
 Examined the relationship between firm value and financing choice (capital
structure).
 Their analysis was based on perfect market assumptions.
 They undertook empirical (real world) studies of electric utilities and oil
companies – evidence found supported the conclusion that there is no
relationship between D/E ratios (capital structure) and the cost of capital
in these industries.
 Capital Structure
Assumptions Underlying M & M’s Analysis
Five Perfect Market Assumptions:
 A perfectly competitive market in which all investors have perfect knowledge
and act rationally;
 Investors are perfectly certain about the future profitability of any company;
 All companies can be divided into homogenous risk classes;
 No personal or company tax; and
 Individuals and companies can raise unlimited debt funds at the same rate of
interest.
 Capital Structure
M & M Proposition 1
 In perfect capital markets (with no taxes and no bankruptcy costs) the value of
the firm is independent of its capital structure.
(i.e. capital structure is irrelevant).
 WACC does not vary with changes in the debt/equity ratio.
 The firm's value is determined by its real assets, not by the securities it issues.

PROVIDED
 Personal borrowing is a perfect substitute for corporate borrowing
(i.e. individuals and corporations can borrow at the same rate of interest).
 Capital Structure
M & M Proposition 2
 The issue to be investigated is how exactly does the required return on equity
in a levered firm change as the degree of leverage changes?

 The required rate of return of equity holders in a levered firm can be shown to
be equal to the required rate of return for un-levered equity plus a “financial
risk premium” which is a function of the debt/equity ratio.

Slide 22
 Capital Structure
 Assume NOIu = NOIL

 From M & M Theorem 1 Vu = VL

 Vu = NOIu / r*e

 r*e is the required return on equity capital (and the WACC) in a firm with no
debt (pure equity firm)

 VL = NOIL / r

 where r is the required rate of return on capital (both debt and equity, i.e. the
WACC) in a levered firm.

 r = rd(D/V) + re(E/V)

Slide 23
 Capital Structure
Since from M & M we know that VU = VL, we require that:

r*e = r = WACC = rd (D/V) + re (E/V)

Solving for re (the required rate of return on equity in a levered firm)

re= r*e + (r*e – rd) x D/E

This shows that as the degree of leverage increases, the required rate of
return on equity in a levered firm increases exactly in line with the increase in
the available rate of return.

Slide 24
 Capital Structure
Return On Equity In A Levered Firm
 For capital structure to be irrelevant, the return equity holders in a levered firm
require on their investment must increase in line with the return available to
them.

 As ‘cheaper’ debt is substituted for equity in the capital structure the return
required by the equity holders in a levered firm increases in response to the
increased risk associated with their investment, and thereby (exactly) offsets
the effect on the overall cost of capital of the ‘cheaper’ debt finance.

Slide 25
 Capital Structure
Return On Equity In A Levered Firm
Example 1
Capital structure: equity = 40% debt = 60%
rd = 8% (= cost of debt (for the levered firm))
re* = 8.8% (= return on equity in an unlevered firm = WACC of unlevered firm)

re = re* + (re* - rd) D/E

re = 8.8% + (8.8% - 8%) 60/40
re = 10%

WACC of Levered Firm:

= re (E/V) + rd (D/V)
= (10% x 40/100) + (8% x 60/100)
= 4% + 4.8%
= 8.8% (also = WACC of unlevered firm)

Slide 26
 Capital Structure
Return On Equity In A Levered Firm
Example 2
If capital structure now changes so debt increases to 70%, M & M argue this
will increase the financial risk to shareholders (of the levered firm) and their
required rate of return will increase.
re = re* + (re* - rd) D/E
re = 8.8% + (8.8% - 8%) 70/30
re = 10.67%
So, after capital structure changes:
WACC of Levered Firm:
= re (E/V) + rd (D/V)
= (10.67% x 30/100) + (8% x 70/100)
= 3.2% + 5.6%
= 8.8%. Therefore, there is no change in WACC.

Slide 27
 Capital Structure
Debt And Risk
Types of Risk
1. Business Risk - Risk due to the nature of the products sold by the company
e.g. risk posed by new competition, technological improvements, etc. All
businesses face Business Risk.
2. Financial Risk - Risk due to using debt (directly related to amount of debt in
the capital structure). Only businesses that use debt financing face Financial
Risk.

 Debt is an additional source of risk, so shareholders’ expected return increases

as a firm uses (more) debt.

Slide 28
 Capital Structure
Composition of Shareholders’ Required Rate of Return
 re = Rf + BRP + FRP

Risk-free rate of Business Risk Financial Risk

return – reflects Premium - reflects Premium – risk
the time-value of the risk inherent in introduced through the
money the firm’s operations addition of debt to the
firm’s capital structure

Slide 29
 Capital Structure
Debt And Risk
M & M Proposition 2
Thus, the expected return to equity holders is equal to the required rate of return
for un-levered equity plus a financial risk premium that is a function of the debt-
equity ratio.
D
re = re* + (re* - rd)
E

Business Financial
Risk Risk

re = rate of return required by shareholders in a levered firm

re* = rate of return required by shareholders in a un-levered firm
rd = rate of return required by debt holders (in a levered firm)

Slide 30
 Capital Structure
Conclusion From Proposition 2
 Increasing (or decreasing) leverage does not affect the cost of capital.
 The cost of debt (rd) is an explicit cost included in the cost of capital.
 The financial risk created by leverage is an implicit cost of debt which
increases the cost of capital by increasing the required rate of return of equity
holders (re).
 M & M Proposition 2 can be summarised as: re varies linearly (and positively)
with changes in financial leverage and offsets the effect on r (WACC) of the
lower cost of debt.

Slide 31
 Capital Structure
M & M Proposition 3
 The appropriate discount rate for a particular investment proposal is
completely independent of how the investment is financed. Therefore,
the financing decision is irrelevant from the point-of-view of maximising
shareholder wealth.
 The appropriate discount rate depends on the features of the investment
proposal, especially the risk (and does not depend on how the investment is
financed).

Slide 32
 Capital Structure
Introducing Market Imperfections
 In their study M & M then went on to relax the assumption of perfect markets and introduced
markets imperfections, specifically, taxation.
Conclusion:
 Interest is tax deductible.
 Thus, borrowing provides a tax saving.
 Thus, the value of a levered firm will be greater than the value of an equivalent un-levered firm
by the present value of the tax saving.

i.e. VL > VU

where VL = VU + P.V. of the tax savings on interest

This can be expressed more formally as:

VL = VU + (D)(Tc),
where:
Vu is the value of the unlevered firm
D is the total debt of the levered firm
Tc is the corporate tax rate

Slide 33
 Capital Structure
Imperfect Markets And Capital Structure
In an imperfect market:
1. Levered firms have additional tax deductions associated with interest
payments; and
2. The value of a levered firm will be greater than the value of an equivalent un-
levered firm by the present value of the tax benefits.

 The two above facts imply the existence of an optimal capital structure –
all debt.

Slide 34
 Capital Structure
Imperfect Markets And Capital Structure
Why Are All Debt Capital Structures Not Observed?
 In the real world companies financed 100% by debt are rare. This is because
there are factors that offset the tax advantages of debt finance when borrowing
becomes too high. These factors are:
1. Personal Taxes
2. Financial Distress Costs
3. Conflict of Interest Costs

Slide 35
 Capital Structure
Why Are All Debt Capital Structures Not Observed
1. Personal Taxes
 The impact of the introduction of personal taxes in relation to capital structure
is beyond the scope of this course and will be ignored.
 What we are interested in (and what you may be examined on) is:
2. Financial Distress Costs, and
3. Conflict of Interest Costs

Slide 36
 Capital Structure
2. Financial Distress Costs
 Financial Distress: When a firm cannot meets its creditor commitments.
 Financial Distress Costs: Costs of managerial time devoted to avert failure/bankruptcy,
fees paid to insolvency specialists and lawyers, etc.

Direct v. Indirect Financial Distress Costs

 Direct costs - Those costs directly associated with bankruptcy, e.g. legal and
administrative expenses.
 Indirect costs - Those costs associated with attempting to avoid bankruptcy, e.g.
restructuring costs, redundancy costs.

Static Theory of Capital Structure

In regards to Financial Distress Costs, the Static Theory of Capital Structure states: A
firm should only borrows up to the point where the tax benefit from an extra dollar in
debt is exactly equal to the cost that comes from the increased probability of financial
distress.

Slide 37
 Capital Structure
3. Conflict of Interest Costs
 Conflict of Interest Costs arise because debt holders may fear management
will transfer wealth from themselves (i.e. from debtholders) to shareholders.
 Therefore, debtholders need to protect themselves from erosion of their
wealth. The way that they do this is to increase rd (the cost of debt) as the
level of debt in the firm rises, or by imposing covenants (i.e. restrictions on
what the firm can and cannot do).
 Conflict of Interest Costs are likely to increase as the D/E ratio increases.
 Conflict of Interest Costs are part of Financial Distress Costs

Slide 38
 Capital Structure
Selected Australian Industry Average Capital Structures

Industry Description % of Debt In Capital structure *1

Utilities 40.00
Food & Staples Retailing 30.00
Food, Beverages & Tobacco 22.00
Consumer Durables & Apparel 18.00
Retailing 13.00
Pharmaceuticals 8.00
Insurance 7.00

*1
Parrino et. al, Fundamentals of Corporate Finance, John Wiley & Sons, 2011, p. 587.
 Capital Structure
Selected Australian Company Average Capital Structures

Company % of Debt In Capital structure *1

Foster’s Group 43.40
Wesfarmers 40.60
Telstra 35.70
David Jones 34.20
Amcor 31.60
Orica 21.00
BHP-B 15.00
QANTAS 8.70

*1
Peirson et. al, Business Finance, ed. 10, McGraw-Hill, 2009, p. 363.
 Capital Structure
Does Capital Structure Really Matter?
Information about listed companies’ capital structures is widely reported. The following are
some examples:

Newspaper Report: ‘Centro Properties still faces big challenges’

Ross Kelly, The Australian, August 31, 2010.
‘[Centro] said it has $18.6bn of investment properties and $18.4bn of related debt, with its
net equity attributable to members at negative $2.1bn. This is clearly an unsustainable
capital structure," it said.

ASX Announcements Re Photon Group Ltd (PGA)

07/06/10 – Market Release ‘Trading Halt’ ‘Photon Group Limited requests that its shares
be placed in an immediate trading halt pending an announcement by it regarding its
financial position and capital structure.’
28/07/10 – ASX Media Release ‘Announcement on trading performance and capital
structure.’ – ‘Photon has commenced a review of its capital structure which is ongoing.
The review is considering a range of options to reduce existing debt and manage
liabilities…..’
 Dividend Imputation
Part 2. Dividend Imputation
 A Dividend Imputation System integrates personal and corporate taxes and
allows corporate taxes paid by companies to be allocated to shareholders by
way of imputation/franking credits.
 The credits are included in the shareholder’s taxable income and the
shareholder is then entitled to a tax rebate, where the tax rebate is equal to the
tax credit included in the shareholder’s income
 If perfectly done it means taxes are only levied at the personal level, so their is
no double taxation of dividends (shareholders pay the tax, rather than
corporations). The tax paid by corporations can be viewed as a collection of
personal taxes, rather than a tax levied on operating income.
 Only in a few countries (including Australia) is the full amount of the corporate
tax paid distributed as a tax credit .
 Dividend Imputation
Franked Dividends
Village Roadshow Limited (VRL)*1
(Example of information provided in an ASX Listed Company Information Fact Sheet)

Div Amount*2 Ex Div Date*3 Record Date*4 Date Payable*5 Franked*6 Type*7 Further Information*8
6c 12/11/2009 18/11/2009 02/12/2009 100% Final 6C Franked @ 30%

*1
http://www.asx.com.au/asx/research/companyInfo.do?by=asxCode&asxCode=VRL: ASX Listed Company Information Fact
Sheet - Village Roadshow Limited (VRL), 30/09/2010.

*2
The dividend is shown as cents per share, expressed in Australian Dollar terms.
*3 Ex Dividend Date – to be entitled to the dividend the shareholder must have purchased shares before the ex dividend date.
*4 Date on which the company closes its register to determine which shareholders are registered to receive the dividend.
*5
Date on which the company pays the dividend to those shareholders who were registered by the Record Date.
*6
The shareholder is entitled to an imputation credit, or reduction in the amount of income tax that must be paid, up to
the amount of tax already paid by the company. The % figure represents the % of tax already paid by the company.The
information represents values applicable to holders of ASX quoted securities who are Australian residents for
Australian tax purposes.
*7
All dividends are classified by ASX as either interim or final. The last dividend in the company’s financial year is classified as
final and all others are classified as interim. Some dividends may also be classified as “special” in accordance with the advice
given by the company about the dividend.
*8
This field contains additional information regarding a share or dividend, e.g. annualised yield, beta, buy back, etc.
 Dividend Imputation
In Summary:
 Corporate tax is paid by the firm.
 Dividends paid out of earnings that have been taxed at the full Australian
corporate tax rate (tc) are termed franked dividends and the tax credit
allocated to shareholders is equal to: dividend x (tc /1- tc)

Example
 Corporate tax rate = 30%
 Dividend paid to shareholder = $700
 Therefore, tax credit = $700 x (0.3/1-0.3)
= $700 x (0.3/0.7) = $700 x (0.4286) = $300
 Therefore, grossed-up dividend = $700 + $300= $1000 
 Dividend Imputation
 For each dollar of franked dividends received by a shareholder the shareholder
will be taxed on a grossed-up dividend, which is the cash dividend plus the tax
credit.

 The shareholder is allowed to apply the tax credit against any tax payable on
their income.

 Non-resident foreign and tax-exempt investors are not eligible for imputation
tax credits
 Dividend Imputation
Example: Company Calculations

Pre-tax operating cash flow 1000

(per shareholder)
Less corporate tax (@ 30%) 300
Cash dividend available to each shareholder 700
Shareholder Calculations
Personal income tax rates: 15% 30% 45%
(low (middle (high
income income income
earner) earner) earner)
Cash dividend 700 700 700
Imputation tax credit 300 300 300
Grossed up dividend/Taxable income 1000 1000 1000
Shareholders tax liability 150 300 450
i.e. 15% of $1,000 i.e. 30% of $1,000 i.e. 45% of $1,000
Less imputation tax credit 300 300 300
Additional tax payable -150 (tax rebate) 0 (no tax) +150 (tax liability)
After all tax flow $850 i.e. $700 $700 i.e. $700 $550 i.e. $700
dividend + $150 dividend only. dividend less $150
rebate. liability.
 Dividend Imputation
A Fully Integrated Dividend Imputation System

 If the dividend imputation system is fully-integrated there is no advantage to

corporations from using debt (i.e. leverage). For this to be the case:
 Shareholders need to be able to take full and immediate benefit of any tax
credits;

 There must be no time delay between the payment of corporate taxes and
the benefit of the tax credits becoming available to shareholders; and

 All corporate earnings are paid out immediately

 Dividend Imputation
Dividend Income v. Debt Income
 Comparing a dollar of dividend income with a dollar of debt income when
there is:
1. Complete dividend imputation; and
2. Personal tax on debt and equity are equal.
Dividend Imputation
 Dividend Imputation
Dividend Policy With Imputation v. Capital Gains
 Dividend Policy With Imputation: company profits paid out as franked
dividends are effectively taxed at the shareholder’s marginal tax rate.
Example
 For each dollar of company taxable income (profit) the company will pay
30 cents in tax, leaving 70 cents that can be paid out as franked income.
 An Australian resident receiving the 70 cents franked dividend will be
taxed on an income of a dollar (the dividend of 70 cents plus the franking
credit of 30 cents).
 If the shareholder has a marginal tax rate of 45% (high income earner) the
net tax payable by the investor after the tax credit will be 15 cents, netting
the shareholder $0.70 less $0.15 = $0.55.
 i.e. $1.00 (dividend of $0.70 plus $0.30 franking credit) x 0.45 (tax rate for
high income earners)) = $1.00 x 0.45 = $0.45 in tax;
 less $0.30 franking credit;
 total tax payable = $0.45 less $0.30 = $0.15.
 Net shareholder income = $0.70 dividend less $0.15 net tax = $0.55.
 Dividend Imputation
Dividend Policy With Imputation v. Capital Gains
Short-Term Capital Gains v. Long-Term Capital Gains
 With long-term capital gains tax is only levied on 50% of the capital gain,
whereas with short-term capital gains tax is levied on the full amount of the
gain.
 Dividend Imputation
Dividend Policy With Imputation v. Capital Gains
Short-Term Capital Gains v. Long-Term Capital gains (cont.)
 If, instead, the $0.70 cents is not paid out as a dividend but retained by the company (as
retained earnings) it results in a capital gain to the shareholder when the share is sold.
 The theory is earnings per share retained by the firm increase the market value of the
firm’s shares by the amount of retained earnings per share.
Short term capital gains - share sold within 1 year of purchase
 If the share is sold less than one year after purchase the $0.70 cents gain will be taxed
at 45 %, meaning the shareholder’s tax bill will be $0.70 x 0.45 = $0.315.
 Therefore, the shareholders after tax income will be $0.70 less $0.315 = $0.385, which
is less than the 55 cents the shareholder would have received if the dividend ($0.70) is
paid out as a franked dividend.
Long term capital gains - share sold more than 1 year after purchase
 If sold more than one year after purchase the taxable gain = 50% of $0.70 = $0.35 and
the tax paid by the shareholder will be calculated on the $0.35 as $0.35 x 0.45 = $0.1575
cents.
 This leaves $0.70 less $0.1575 = $54.25 as the shareholder’s net receipt (which is
slightly less than the $0.55 the shareholder would have received if the dividend ($0.70) is
paid out as a franked dividend).
 Dividend Imputation
The Australian System
 The Australian system is close to, but not fully, integrated for domestic
shareholders (remember, with a fully-integrated dividend imputation system
there is no advantage to corporations or investors from using debt (i.e.
leverage)).

 Why is the system not fully-integrated? Because in Australian there is a

mixture of investors and corporations who face different tax regimes and
rates.

 As a consequence, shareholders could have different preferences to

corporations (which have particular capital structures) when it comes to the
paying of franked dividends (as against, for example, retained earnings).