15.5How Dividend Taxes Affect Financing and Investment Choices

Although it is very difficult to determine whether the taxation of dividends is reflected

in stock returns, it is true that some investors incur a tax penalty when they receive

dividends. In addition, firms impose taxes and transaction costs on their shareholders

when they distribute excess cash by repurchasing shares. These taxes and transaction

costs can distort investment and financing choices.

Dividends, Taxes, and Financing Choices

This subsection reexamines the capital structure decision from the perspective of a firm

that subjects its stockholders to personal tax liabilities when it distributes a portion of

its earnings to them. Recall from Chapter 14 that the U.S. tax system biases firms

towards issuing debt rather than equity financing. However, the analysis there largely

¹¹That series B (cash dividend) shares in the early time period were priced to yield less than the

series A(stock dividend) shares probably reflected the fact that the stock dividends were initially higher

than the cash dividends, implying that the stock dividends were likely to fall relative to the cash

dividends. Indeed, the dividends on series Aand B shares are currently identical and their prices are the

same. (Both share classes currently pay stock dividends, but Citizens Utilities provides a service to its

series B shareholders whereby it sells the stock dividends and distributes the cash proceeds to the

shareholders.)

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ignored the distinction between internally generated and externally generated equity.

This distinction is quite important, however, if distributed earnings are taxed at high

personal rates.

Dividends, Taxes, and Investment Distortions

The personal tax on dividends affects a firm’s choice between paying out earnings and

retaining them for internal investment. This section illustrates that shareholders who are

taxed differently on their dividend income favor different investment policies for their

firms.

The Investment Policy Favored by Tax-Paying Shareholders.Assume that you

own shares in Continental Corporation and have a marginal tax rate on personal income

of 50 percent. Suppose that Continental Corporation must decide whether to pay out

an additional $1 million in dividends or to retain the earnings for internal investment.

As the holder of 10 percent of the outstanding shares, you have a major say in the deci-

sion and need to consider the possibilities seriously. Your advisors calculate that over

the next five years the firm will earn 6 percent after corporate taxes with certainty on

the $1 million and that these earnings will be distributed to the shareholders in addi-

tion to the dividends they would have received otherwise. At the end of the five years,

the $1 million retained this year will be distributed to shareholders. In essence, the

choice for shareholders is whether to defer the $1 million dividend for five years and

receive, as compensation for this deferral, additional annual dividends of $60,000 per

year ( $1 million .06) in the interim period. Deferral does not seem particularly

attractive at first glance because the rate of return on five-year U.S. Treasury bonds is

7 percent, which is where you would invest the dividend if it was paid now.

Your tax advisors, however, urge you to compare the after-tax cash flows from

these alternatives, which appear in Exhibit 15.5. They suggest that, given your 50 per-

cent marginal tax rate on personal income, you are better off if the money is retained

within the corporation. After taxes, the immediate $100,000 dividend (10 percent of

the $1 million distribution) would be worth only $50,000, which, according toAlter-

native 1in Exhibit 15.5, generates only $1,750 per year after taxes if invested at 7

percent.

The after-tax cash flows on the internally invested retained earnings, Alternative 2

in Exhibit 15.5, are higher than those on the distributed dividends, Alternative 1. A

return is earned on the entire$1 million of earnings kept within the firm rather than

on halfthis amount, as is the case forAlternative 1,because the earnings are distrib-

uted. As a result, tax-paying investors tend to prefer retaining the earnings within the

firm rather than receiving a cash dividend.

The Investment Policy Favored by Tax-Exempt Shareholders.Tax-exempt insti-

tutions would evaluate these alternatives quite differently. From their perspective,

assuming the same 10 percent ownership of the outstanding shares, cash flows would

be as specified in Exhibit 15.6. Thus, from the perspective of a tax-exempt institution,

a cash dividend, Alternative 1, would be preferred.

Payout Policy and the Personal Tax Rate on Distributions.Note that the tax rate

on the distribution to the equity holders does not directly affect the comparison in

Exhibit 15.5. If the distribution were taxed at a capital gains rate that is considerably

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548Part IVCapital Structure

EXHIBIT15.5After-Tax Cash Flows fora Taxable Investor

Alternative 1:Investment of after-tax dividend of $50,000 in Treasury bonds.

After-Tax Cash Flows

					Principal
Year 1	Year 2	Year 3	Year 4	Year 5	Payment

$1,750

$1,750

$1,750

$1,750

$1,750

$50,000

Alternative 2:Retain earnings and invest internally for five years, which returns 6 percent to

stockholders per year with a final dividend in year 5.

After-Tax Cash Flows

					Deferred
Year 1	Year 2	Year 3	Year 4	Year 5	Dividend

$3,000

$3,000

$3,000

$3,000

$3,000

$50,000

EXHIBIT15.6Cash Flows fora Tax-Exempt Investor

Alternative 1:Investment of $100,000 dividend in Treasury bonds

Cash Flows

					Principal
Year 1	Year 2	Year 3	Year 4	Year 5	Payment

$7,000

$7,000

$7,000

$7,000

$7,000

$100,000

Alternative 2: Retain earnings and invest internally for five years, which returns 6 percent to

stockholders per year with a final dividend in year 5.

Cash Flows

					Deferred
Year 1	Year 2	Year 3	Year 4	Year 5	Dividend

$6,000

$6,000

$6,000

$6,000

$6,000

$100,000

less than the 50 percent rate, the conclusion would be exactly the same. What is impor-

tant is the difference between the after-tax rate of return from investing inside the cor-

poration versus investing outside the corporation.

The tax rate on the distribution is irrelevant because the cash must eventually be

distributed, either now or later, and the tax rate on the distribution is assumed to be

the same in either case. However, if there are expected to be changes in the tax rate

on the distribution, such changes could affect the payout/reinvestment decision. If, for

example, tax rates on distributions are expected to increase, there will be an increased

incentive to pay out cash flows now, when the tax on distributions is low, rather than

later, when the tax rate on distributions is higher. Similarly, a corporation will have

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an incentive to delay distributions if it believes that the tax on distributions is going

to decline.

These considerations suggest that a corporation, investing on behalf of taxable

investors, may find that investment from retained cash is subject to a less stringent cri-

terion than investment financed with outside equity. To understand this point, consider

the following example:

Example 15.5:The Effect of Personal Taxes on Corporate Investments

GT Associates can earn 15 percent before taxes on its investments.However, being taxed

at a 33.33 percent rate on corporate income, it earns only 10 percent after taxes.Equity

investments that exactly track the future cash flows of GT’s projects have a pretax rate of

return of 10 percent and are taxed at a 20 percent personal capital gains tax rate at the

time the gain is realized.The 10 percent return on the tracking portfolio is GT’s cost of cap-

ital (see Chapters 11 and 13), as it represents the financial market’s alternative to an invest-

ment in the real assets of GT.GT has an investment opportunity that costs $125 million and

earns 10 percent, after taking out corporate taxes, which is exactly the firm’s cost of capi-

tal.Describe how GT would assess the profitability of this project, (1) in the case where GT

must raise outside equity to fund the project and (2) where it has internally generated cash

that it would otherwise distribute to its shareholders.

Answer:(1)Observe that the project, with an after-corporate tax return equal to the 10

percent cost of capital, has a zero NPV.Hence, if funding the project requires outside equity,

the firm should be indifferent about taking on the project.To understand this point in the

presence of personal taxes, we first need to recognize that the capital gains rate in this case

is irrelevant for assessing whether GT makes money, loses money, or breaks even on inter-

nal investments funded by external equity.As an alternative to its investors’tracking portfo-

lio, GT can raise $125 million externally by issuing additional equity.In its zero-NPVproject,

the $125 million grows to $137.5 million in the next year.

What happens if the $137.5 million in cash from the project is returned to GT’s

investors? Repurchasing the previously issued equity after one year provides GT’s

investors with $137.5 million in cash, minus a $2.5 million capital gains tax (20 percent of

the $12.5 million gain), for a total after-tax payout of $135 million.This is exactlywhat GT’s

investors would have received after capital gains taxes by acquiring the tracking portfolio

for $125 million, watching it appreciate over the year, and liquidating it at the end of the

year.This is not surprising since zero-NPVinvestments are by definition those that do not

create or destroy wealth for a firm’s investors relative to the alternatives available to them

in the financial markets.

(2)Now suppose GT has $125 million of internally generated cash.Let’s compare the

consequences of either paying out the $125 million to GT’s shareholders by repurchas-

ing shares immediately or investing it internally at the after-tax rate of 10 percent and

repurchasing shares one year later.If it pays out the $125 million immediately, GT’s

investors will receive $100 million after paying the capital gains tax, which they can invest

in the financial markets to receive $108 million after capital gains taxes one year later.

However, if GT invests the $125 million internally in a project that earns 10 percent after

taxes, it will have $137.5 million to distribute to its shareholders the following year.Under

this alternative, and after paying the 20 percent capital gains tax on the $137.5 million

capital gain, the investors will be left with $110 million.This amount exceeds the $108

million they would have earned had GT distributed the $125 million in cash in the previ-

ous year.In this sense, the project, despite being a zero-NPVproject when financed with

outside equity, creates $2 million in wealth at the end of the period for GT’s sharehold-

ers when funded with internal cash.This $2 million in wealth is the benefit of deferring

the $25 million in taxes on unrealized capital gains of $125 million for an additional year

at the 8 percent after personal tax rate of return.

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550Part IVCapital Structure

Summary of How Personal Taxes Influence Investment Choices.In general,

investors prefer retained earnings over a cash dividend (or share repurchase) if expected

returns, adjusted for their premiums due to risk, satisfy:

(1T) (pretax return within the corporation)
c
	(15.4)
(after personal tax return outside the corporation)

Otherwise, investors prefer the cash dividend (or share repurchase).

Note that the entire left side of the inequality is simply the project’s return, com-

puted as is usually done from after corporate tax cash flows, whereas the right side is

the product of the return of the tracking portfolio (that is, the project’s cost of capital)

and (1 personal tax rate on the distribution). Hence, inequality (15.4) can be con-

trasted with theNPVrequirement discussed in Chapter 13—that investment projects

funded with externally raised equity must earn an after tax rate of return that exceeds

the pretax rate of return investors can earn in the financial markets from the project’s

tracking portfolio:

(1T) (pretax return within the corporation)
c
	(15.5)
(pretax return outside the corporation)

Acomparison of expressions (15.4) and (15.5) reveals that for tax-exempt share-

holders, the two expressions are identical. Hence, a tax-exempt investor will want

the corporation to make the same real investment choices regardless of whether the

investment is funded from retained earnings, which would otherwise be paid out as

a dividend, or with a new equity issue. These expressions, however, are not equiv-

alent for investors who are subject to personal taxes on dividend distributions or

share repurchases. These investors will require a lower rate of return on investments

that the corporation funds from retained earnings if the alternative is a taxed

distribution.

The above discussion is summarized in Result 15.6.

Result 15.5

Tax-exempt and tax-paying shareholders agree about which projects a firm should fund fromexternal equity issues but may disagree about which projects should be financed fromretained earnings. In particular:

•	Tax-exempt shareholders require the same expected return for internally financed projects as they do for externally financed projects.
•	Tax-paying shareholders prefer that firms use lower required rates of return forinternally financed projects if the alternative is paying taxable dividends orrepurchasing their shares.

To summarize, the discussion in this section suggests that the investment policies

preferred by shareholders, who are subject to personal taxes, may differ from the poli-

cies described in Chapter 14 for firms that are generating significant amounts of cash.

The hurdle rate required by the firm with cash on hand should be lower than the hur-

dle rate required of a corporation that must raise equity to fund the investment. This

does not mean, however, that a corporation with cash should be taking on projects with

very negative NPVs. The opportunity cost of a project is still the rate of return that can

be earned by investing in equivalent investments in the financial markets. This return

can be viewed, on an after corporate tax basis, as an alternative to what the firm can

earn from investing in real assets.

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Disagreements at Microsoft

Consider a corporation, like Microsoft, which by 2001 had accumulated about $20 billion in

excesscash (that is, cash not currently needed for debt repayment or investment). Equation

(15.5) suggests that tax-exempt institutional investors prefer the firm to pay out the cash as

a dividend. However, equation (15.4) suggests that Bill Gates, Microsoft’s CEO, and other

shareholders with higher marginal tax rates than the corporation, prefer to have the corpora-

tion retain the earnings and invest the money in Treasury bonds. Shareholders with the same

marginal tax rate as the corporation will be indifferent between the two alternatives.

Although companies like Microsoft sometimes invest excess cash in government bonds

and equivalent instruments, Gates may prefer alternative uses for these funds. For example,

Gates may prefer to diversify his portfolio by using Microsoft to buy another company’s

stock instead of buying the stock with his personal money. Since U.S. corporations are taxed

on only 30 percent of the dividend income they receive from other corporations, they can

often earn a higher after-tax rate of return by buying the common or preferred shares of

other companies than they can earn from holding debt instruments like T-bonds.¹²

Recall from Chapter 14 that because corporations are taxed on only 30 percent of

the dividends they receive from other corporations, many U.S. firms invest their excess

cash in preferred stock rather than corporate or government bonds. As Chapter 3 noted,

financial institutions recently designed a number of variations of preferred stock that

take advantage of this tax preference. As a result, the tendency of corporations to invest

their excess cash in preferred stock has increased since the mid-1980s. Because firms

can invest their excess cash in preferred stock that is taxed at a lower rate, they find

it more attractive to reduce dividends and invest their earnings internally.