Page 211 - DCOM508_CORPORATE_TAX_PLANNING

Corporate Tax Planning

Notes

Notes Dividend Policy Ratios

It measure how much a company pays out in dividends relative to its earnings and market
value of its shares. These ratios provide insights into the dividend policy of a company.
They compare the dividends to the earnings to measure how much of its earnings a
company is paying out in dividends. They also compare the dividends to share prices to

see how much cash flow the investors get for their investments in the company’s shares.
Dividend payout ratio and dividend yield are two most common examples of dividend
policy ratios.
Dividend cover is another example of such ratios. Dividend payout ratio gives an idea how
well the earnings support the dividends paid out. Dividend yield measures how much a
company pays out in dividends relative to the market value of its shares.
Dividend policy ratios are affected by the age of a company. Companies which are mature,
stable and large in size usually pay higher dividends. Therefore dividend policy ratios of
such companies are usually high. On the other hand, companies which are young, small
and seeking growth usually do not pay any dividends or pay very modest dividends.
Therefore dividend policy ratios of such companies are not so handsome.

9.2.4 Tax Implications on Dividend Policy

The decision to pay dividends to investors does not have an impact on a company’s corporate
tax. Large investors can sometimes pressure the corporate board of directors, infl uencing their
decision to pay dividends or not. During years when dividend taxes are lower than capital gains
taxes, more companies use their excess cash to pay investor dividends. During times when
dividend taxes are high relative to capital gains tax, fewer companies pay investor dividends.

When a company pays you a cash dividend, it reduces stockholder’s equity for each share of
stock. Stockholder’s equity is calculated by subtracting company liabilities from assets. Paying
dividends reduces cash, which is an asset. Reducing equity represented by each share of stock
can have a negative impact on the stock’s share price. In other words, paying dividends transfers
some of the company’s value directly to shareholders in the form of cash instead of capital gains.
Because dividend taxes are lower than short-term capital gains taxes, companies can reduce the
tax liability for some of their investors by issuing dividends.

It must also be noted that the dividend policy of a firm is also critically important as it affects both
the corporate and personal taxes.

Example: The Regional Electric Company has ` 1000 of extra cash after tax. The company
has different options to deal with this cash. It can either retain the cash or invest it in T-bills
yielding 10% or it can pay the cash to shareholders as a dividend. Shareholders can also put the
money in T-bills with the same yield. Suppose if the corporate tax rate is 34% and the individual
rate is 28% than what is the amount of cash that investors will have after 5 years under each of
the following scenarios:
Options:
(a) Pay dividends

(b) Retain the cash for investment in the firm earnings paid out to shareholders.

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