Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

18. Dividends and Dividend
    Policy

© The McGraw−Hill^639

Companies, 2002

REAL-WORLD FACTORS FAVORING

A LOW PAYOUT

The example we used to illustrate the irrelevance of dividend policy ignored taxes and

flotation costs. In this section, we will see that these factors might lead us to prefer a

low-dividend payout.

Taxes

U.S. tax laws are complex, and they affect dividend policy in a number of ways. The

key tax feature has to do with the taxation of dividend income and capital gains. For in-

dividual shareholders, effectivetax rates on dividend income are higher than the tax

rates on capital gains. Dividends received are taxed as ordinary income. Capital gains

are taxed at somewhat lower rates, and the tax on a capital gain is deferred until the

stock is sold. This second aspect of capital gains taxation makes the effective tax rate

much lower because the present value of the tax is less.^3

A firm that adopts a low-dividend payout will reinvest the money instead of paying

it out. This reinvestment increases the value of the firm and of the equity. All other

things being equal, the net effect is that the expected capital gains portion of the return

will be higher in the future. So, the fact that capital gains are taxed favorably may lead

us to prefer this approach.

This tax disadvantage of dividends doesn’t necessarily lead to a policy of paying no

dividends. Suppose a firm has some excess cash after selecting all positive NPV projects

(this type of excess cash is frequently referred to as free cash flow). The firm is consid-

ering two mutually exclusive uses of the excess cash: (1) pay dividends or (2) retain the

excess cash for investment in securities. The correct dividend policy will depend upon

the individual tax rate and the corporate tax rate.

To see why, suppose the Regional Electric Company has $1,000 in extra cash. It can

retain the cash and invest it in Treasury bills yielding 10 percent, or it can pay the cash

to shareholders as a dividend. Shareholders can also invest in Treasury bills with the

same yield. The corporate tax rate is 34 percent, and the individual tax rate is 28 percent.

What is the amount of cash that investors will have after five years under each policy?

If dividends are paid now, shareholders will receive $1,000 before taxes, or $1,000

(1 
.28) $720 after taxes. This is the amount they will invest. If the rate on T-bills

is 10 percent, before taxes, then the aftertax return is 10% (1 
.28) 7.2% per year.

Thus, in five years, the shareholders will have:

$720 (1 .072)^5 $1,019.31

If Regional Electric Company retains the cash, invests in Treasury bills, and pays out the

proceeds five years from now, then $1,000 will be invested today. However, because the

corporate tax rate is 34 percent, the aftertax return from the T-bills will be 10% (1 


.34) 6.6% per year. In five years, the investment will be worth:

$1,000 (1 .066)^5 $1,376.53

If this amount is then paid out as a dividend, the stockholders will receive (after tax):

612 PART SIX Cost of Capital and Long-Term Financial Policy

18.3

(^3) In fact, capital gains taxes can sometimes be avoided altogether. Although we do not recommend this
particular tax-avoidance strategy, the capital gains tax may be avoided by dying. Your heirs are not considered
to have a capital gain, so the tax liability dies when you do. In this instance, you can take it with you.