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Tax preference theory

Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA AFM Exams › Tax preference theory

  • This topic has 1 reply, 2 voices, and was last updated 12 years ago by John Moffat.
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  • November 19, 2012 at 1:36 pm #55476
    nomantufail
    Member
    • Topics: 17
    • Replies: 13
    • ☆

    I have read Tax preference theory for dividends and cannot understand how it will effect market value of company. I know that there is remote chance of practical question on this topic. But for conceptual clarity I have constructed the following scenario.

    Given Data

    Current policy is paying Constant dividend of $ 15 each year.
    Shareholders required rate of return is 24%.
    Tax rate on dividends 10%
    Market price per share $150 (ex-div) at beginning of the year.
    Expected capital gain 15% by the end of year (due earning potential of the company).
    Capital gain tax is exempt.
    Transaction costs associated with sale/purchase of shares $ 1% of value involved.

    Required: Effect on market value of company if company decides not to distribute dividends and allow shareholders to take benefit of capital gain tax exemption.

    Solution

    We know that shareholders will value the company on basis of their future cash flow.
    Existing value of the company is based on current dividend policy. So if policy does not change then future cash flow will be $15 less tax on dividend i.e; 13.5 per share.

    But if company decided not to declare dividend then after one year market value of company will increase by 15% and become
    =150 X 1.15 = $ 172.5
    And if shareholder sale one share he will get cash after deducting transaction cost of 1% and net cash inflow will be
    99% X 172.5 = $ 170.775

    I know that market price will be changed because of change in cash inflows but how should I calculate it? Please assume any missing figures which I have not mentioned in the given information.

    Please note that I have calculated require return as follows :
    (net Dividend yield + capital gain yield)/market price = (13.5+22.5)/150 = 24%

    November 19, 2012 at 6:31 pm #107878
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 54699
    • ☆☆☆☆☆

    There are some flaws in your question (and answer).

    Firstly, is the company is paying a constant dividend then this would suggest constant earnings, and therefore there would be no growth. (If they were retaining, then there would be growth, but if they continued paying a contact dividend, the the rate of growth would not be constant).

    Secondly, the capital growth would be higher if there was no dividend, and so it is wrong to assume that the capital gain would be 15% in both cases.

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