Analysis of Flow of Funds - Essay Example

Table of Contents Serial Number Particulars Page Number 1. INTRODUCTION 1 2. EFFECTS OF TAXATION ON DIVIDEND POLICIES 1 3. EFFECTS OF TAXATION ON CAPITAL STRUCTURE DECISIONS 9 4. TAXATION AND CAPITAL STUCTURE 13 5. CONCLUSION 15 Discuss to what extent the existence of corporate and personal taxes could affect companies' dividend policy and capital structure decisions. Introduction It would not be a travesty of truth to extol the role that dividend distribution play in the long term growth and sustenance of a Company. Management Researchers and practitioners are unanimous in their view that the underlying factor of the Company's functioning is to build and increase shareholders' value and is the main cause for its existence, besides brand building and customer satiation. One of the best ways to enhance shareholders' value is to build a consistent dividend policy over the years that could create value addition to the Company and ensure shareholder loyalties by consolidating and building up its position in the turbulent high waters of competitive business operations It is proposed to first take up the impact of corporate and personal taxes on companies' dividend policies. Effects on Company's Dividend Policies Analysis on distribution of dividends: Dividends could be said to be the reward for the shareholders' participation in contributions towards the corpus of company and its management. The dividend policy plays a crucial role in the financial operations of corporate in the UK because it is closely dependent on current profits and also future profitability of the entity. As per law, Companies could distribute dividends, only out of earnings or reserves of the Company, since otherwise; it would amount to paying back its own capital to the shareholders. Thus, a Company could only distribute dividends out of its accumulated profits and free reserves available for such distribution: Options in pursuant to its dividend policy The Company has the following options in pursuant to its dividend policy: It may choose not to pay any dividend and may retain its earnings for future plans, the Company's decision not to pay dividends may stem from the need for maintaining reserves for market expansions, need to buy back shares at later date, building funds for heavy investments projects, programmes, etc. It may decide to pay minimum dividends out of its retained earnings, keeping the long term prospects of the Company in view, with the optimistic view that in future years, it would be able to maintain or increase, the level of profitability, and thus its rate of dividend. This is because a falling rate of dividend may discourage potential investors and they may become circumspect about investing in such companies. This would have detrimental consequences on the company's market image. The Company's operations are such that it is in a strong position to regularly pay high rates of dividends, even quarterly basis, in terms of a strong market position and market realisations. Moreover, because of reputation and goodwill gained by the Company, it is also able to attract outside investors for future growth plans and expansion, and it need not depend entirely on the present earnings and Capital reserves at its disposal. It would not be wrong to say that dividend policies, besides the tax element, is also dependent upon available of consistent profits and dividend yielding assets Role of Taxation in determination of dividend policies: Taxation plays an important role in the determination of dividends because of the following reasons: Incidence of double taxation, especially in developed countries. Capital gains being subject to a lower rate of taxation than dividends Shareholders can retain their shares till their death, and yet their executors of their wills need not have to pay any taxes on the shares held by the deceased shareholders. In the personal taxation laws in the UK the rates are 10% for basic dividend incomes up to 34,600, and, on and above 34,601; the rate is 32.5% of the incomes. Thus it is seen that after the effective credit of 10% the effective rate of taxes on dividends would be 22.5%. This would be seeming on the high side. 1 It is often argued that dividends are the rewards gained by the shareholders for contributing to the corpus, and therefore, it need not been taxed at rates, higher than other incomes. Therefore there has been a strong case for reducing the taxation rates on dividends in the UK Double Taxation: It is often the case, especially in the US that dividend needs to be taxed twice, once when the Company appropriates the profits for dividend distribution, and again, at the hands of the shareholders who received the dividends net of tax, after getting the credit of 10% against the dividend paid to the shareholders. Thus it is often found that in many instances, the shareholders prefer not to receive the dividends, but requires the Company to retain earnings, which could boost the share value, and could fetch higher sale prices, in the event the shareholders, disposes off the share holdings. Thus it is seen that from point of view of the shareholders, dividends do not really contribute much, unless the rates of dividends are very high, and it is the company's policy not to retain earnings but to distribute the same as dividends. Often it is seen that minority shareholders may enforce payment of dividends due to the machinations of insider interests, who may want to divert the Company's resources and earnings to serve their own selfish purposes by wilful misrepresentations, frauds, under valuation of assets and overvaluation of liabilities. Comparative Rates of Taxation: It is seen that the Rate of tax on Capital Gains in the UK is comparatively lower, when compared to rate applicable on dividend incomes, which is 32.5% ( without credit ) and therefore, it is natural that investors would believe in purchase and sale of their shares, which would bring them a higher returns, when compared to Dividend incomes. The main attraction for retaining shares would be in the case of Bonus Issues or Rights issues in which cases, the shareholders would be benefited by holding their shares for a long period of time. At present, the tax payers have a choice of three options, R, R + F and S. R = Real inflow - real outflows R + F = Real inflow - real outflows + (Financial inflow - Financial outflow) S = R = F + (Share inflows - share outflows). 2 It is widely believed that taxation plays an important part in determining the dividend policy distribution, since taxation liabilities would accrue both to the company and also to the ultimate shareholders, although the shareholder could claim credit for the tax deducted at source by the Company. 3 Dividend paid to you (represents 90% of the dividend income) Tax credit (10% of the dividend income) Dividend income (dividend paid plus tax credit) 63 7 70 54 6 60 90 10 100 4 Dividend exemption as benefit of foreign dividends There is a proposal to grant dividend exemption as benefit of foreign dividends paid to UK Companies for foreign dividends received, where the shareholders hold more than 10% of the overseas company .In the present scenario, such dividend receipts are taxed in UK, although appropriate credits are available. This exemption would be recoverable from controllable company where the dividends are paid from income "outside the controlling company rules"5. Impact of taxation on investment & speculative holding The basic question that now arises is that whether the taxation would impact the dividend decision of companies and individuals. In the case of companies, it is seen, that in most cases, the real intentions of the shareholders intentions are paramount, whether it is for purpose of receipt of regular dividends and term holdings, or whether it is for trading purposes. In the class of investors for term holdings, the aspect of taxation is significant since both as individual or corporate holdings, the tax aspect would be significant, and both corporate and individuals would like to lower their tax liability through tax planning and judicious investments. Therefore, it could be reasonably said that judicious investors would look for three aspects liquidity, returns and accretion to share value. The aspect of liquidity is that investors should be able to dispose off the assets if it is deemed necessary to do so; it should provide adequate returns on investments; and also, the Company should take necessary care to see that the share value increases over period of time. The tax aspect is significant in terms of returns, in that the liability of tax would reduce Net Total Income from dividends, and therefore, significant planning needs to be done while investing, including investments in UK Companies situated outside the country, where foreign dividends would accrue. Coming to the aspects of speculative trading, it is seen that it may not be of much significance, since non receipt of dividends could also result in higher reserves being build by the Company which could result in the accretion of share value. In the event of non-receipt of dividends, the holders could be compensated, due to higher market value for the shares. Thus it is observed that the impact of taxation on dividends could affect investments to a certain extent, and would thus also affect its dividend policy. Dividend policy: It is now necessary to understand what are the factors to be considered while drawing up the dividend policy for a Company. In answering such question, it is first of all necessary to distinguish between start up companies and established ones. For start up companies, who have been operating for just few years, it is necessary that they consolidated their position and not concern themselves too much about profits or dividend. They need to create conditions by which they could operate smoothly and ceaselessly and build up profits and reserves over a period of time. It is necessary from them to frame policies that could address to the distribution of dividend and the tax impact on such dividends, especially to foreign stakeholders. Although profits may fluctuate over time depending upon the performance of the Company, it is necessary to maintain consistent dividends and controlled tax liabilities arising from such dividends. Moreover, unlike preferential dividends, Companies could defer the payment of equity dividends, and thus reduce tax liabilities on such share capital, which cannot be done for preferential dividends which is an obligatory payment, like interests, which need to be paid even in the event of losses or inadequacy of profits. Therefore the main considerations for the company would be in terms of the following: Whether dividends need to be declared and distributed and if so, What is the quantum of dividend including its tax obligations Could it be possible to maintain this dividend and resultant tax obligation Would it inure sufficient internalisation of earnings to meet future capital needs It is now proposed to venture to the second aspect of this study, and that is the impact of taxation on capital structure decisions and how taxation considerations underpin the choice of adequate and suitable capital structure model for corporates. Effects on Companies 'Capital Structure Decisions Capital structure refers to the mix of sources from which the long term funds required in a business may be raised. That is what should be the proportion of equity share capital, preference share capital, internal sources, debentures, and other sources of funds in the total amount of capital, which an undertaking may raise for establishing its business. While deciding a capital structure for an organisation, certain factors like the nature of industry, gestation period etc. need to be considered. In addition to this, government policy is also crucial for planning the capital structure. The capital structure is said to be optimum capital structure, when the firm has selected such a combination of equity and debt so that the wealth of the firm is maximised. At an optimal capital structure, the cost of capital is minimal, and the market price per share is maximised, and thus the risk to capital should be very low. However, it is quite arduous to find out an optimum debt and equity mix where the capital structure would be optimum, because it is difficult to measure a fall in the market value of an equity share on account of increase in risk due to high debt content in the capital structure. From a practical point of view, in terms of organisational consideration, appropriate capital structure is more realistic than an optimal capital structure. In a resource constraint situation importance of financial management is especially high lighted as financial strategies are required to get the company or organisation through the constraints position. The reasons behind these constraints could be lack of demand, scarcity of raw materials, labour problems, liquidity control, lack of technological awareness, prejudiced policies about management and finance etc. If the problem is not taken in to consideration during the initial stage itself, then it will leads to severe bankruptcy and sickness. Under these circumstances, the role of financial management is to decide upon whether the organisation's continuance is a viable option or not. But during these situations, when corporate viability itself is in doubt, the alternative of winding up the operation should be explored. But it is necessary that these problems be solved through proper strategies. After making estimation about the requirements of funds, a decision regarding various sources from where these funds would be raised is essential. For this, it is essential to analyse a proper mix of the various internal sources; because each sources of funds should be differentiated from one another. In this context, the financial manager has to carefully look in to the existing capital structure and also consider the proper raising of funds. While analyzing the capital structure decision of an organisation, it is very important to consider the certain factors or concepts like profitability, solvency, flexibility, preservation, and control. While maintaining a capital structure planning, there are three major considerations like risk, cost of capital, and control is significant, which help the financial manager in determining the proportion in which the funds should be raised from various sources. The financial manager attempts to design the capital structure in such a manner that the risk and costs are the least and the control of the existing management is diluted. In addition to this, there also subsidiary factors like marketability of the issue, flexibility of the capital structure, and timing of raising the funds. Aspects of capital structuring Capital structure is the factor, which is determining the value of the firm, and the firm would like to have a capital structure which maximizes the market value of the firm. The capital structure theories may be mainly classified in to four- Net Income Approach, Net Operating Income Approach, Traditional theory, and Modigliani and Miller Approach. These four approaches should analyze the relationship between the leverage, cost of capital, and the value of the firm in different ways. Net Income Approach is based on the fact that if the degree of financial leverage increases the weighted average cost of capital will decline with every increase in the debt concept in total funds employed by the firm, while the at the same time there will be an increase in the value of the firm. So, the value of the firm under this method means; V= S+D; Where, V= Value of the firm. S= Market value of equity D= Market value of debt. Net Operating Income (NOI) Approach means the market value of the firm is not affected by the capital structure changes. The market value of the firm is computed by capitalizing the operating income at the overall cost of capital which is stable in nature. Market Value of the Firm (V) = EBIT (Earnings before Interest & Tax)/Overall Cost of Capital. OR "V (Valuation) =NOI (Net Operating Income) / R (Capitalization Rate)." 6 But under Traditional Approach the cost of capital is a function of financial leverage and the value of a firm can be affected by the adequate mix of both debt and equity. According to Modigliani and Miller Approach (M&M Approach), Weighted Average Cost of Capital (WACC) of a firm is completely independent of its capital structure. Moreover, the cut off rate of investment purposes is absolutely free of the way in which the investment is financed. But M&M Approach is criticised due to the perfect market assumption and arbitrage assumption. Moreover, there is lack of empirical research, which is giving stress that the cost of capital of a firm can be lowered and the market value of the shares can be increased by a careful use of financial leverage. The determination of an optimal capital structure is effective for the better implementation of an organisational capital structure and cost of capital. Therefore, for designing the optimal capital structure, a financial manager is required to select a wide mix of sources of finance, so as to minimise the overall cost of capital. The composite of overall cost of capital of a firm is considered as the weighted average cost of several sources of funds. While making the financial aspect of investment decision, it is essential to give stress to the overall weighted costs. Weights are taken as the proportion of each source of funds in the overall capital structure of an entity. The computation of WACC is a step by step procedure, such as Calculating the cost of specific sources of funds, then multiplying the cost of each source by its proportion in capital structure, and adding the weighted component costs. While measuring the cost of capital, major sources of finance are cost of debt, cost of preference shares, cost of equity, and cost of reserves. Estimated Statement Showing Weighted Average Cost of Capital. ( prepared by writer) Particulars. Amount in (). Proportion. After taxation cost. Weighted costs. Equity capital Retained earnings Debt. 5,00,000 2,00,000 3,00,000 0.50 0.20 0.30 0.18 0.18 0.065 0.09 0.036 0.0195 TOTAL WACC 0.1455 14.5% Assumptions- 1. The component costs before tax are: Equity capital 18%, Debt 10%. 2. WACC: - After tax cost of debt= KD (1-T) =10 %( 1_0.35) =6.5%. Taxation and Capital Structure As far as an optimal capital structure is taken in to consideration, the importance is being provided for both equity and debt. But in case of taxation matters, the concept of debt will be more beneficial than that of the equity. This is because, in debt matter, it is obligatory to pay interest on debt, and such amount of interest should be deductible from the total income, which is before considering the taxable income. It helps to reduce the total amount of tax being paid. But on the other hand, in case of equity, there is no need of deducting the amount of dividend provided to equity holders out of the total income; so there should not be any more deduction in the tax amount. The major advantages of debt or borrowing are benefit in the tax payment, and it also added control and regulation over the management. Similarly, debt is also having its own limitations like, liquidation cost, agency cost, and the loss of future financing flexibility. 7 Assumptions of the Modigliani and Miller Approach (M&M Approach), The tax concept and effective capital structure decision is related to the major assumptions of M&M Theory. They are- The capital markets are assumed to be perfect. Because the investors are free to buy or sell securities. The firm can be classified in to homogenous risk class. All investors have the same expectations from a firm's net operating income, which are necessary to evaluate the value of a firm. There are no retained earnings, so the dividend payment ratio is 100%. There are no corporate taxes. The leverage irrelevance theorem of MM is valid if the perfect market assumptions underlying their analysis are satisfied. However, in the face of imperfections characterizing the real world capital markets, the capital structure of a firm may affect its valuation. But as far as the real situation of the world is taken in to account, the presence of taxes is a major limitation. When the taxes are applicable to corporate income, debt financing is advantageous. This is because dividends and retained earnings are not deductible for tax purpose, but interest on debt is a tax deductible expense. As a result, the total income available for both stock holders (equity) and debt holders (debt) is greater when debt capital is used. Conclusion: Thus it has been seen that there are various factors that impinge upon the existence of corporate and personal taxes that could impact companies' dividend policy and capital structure decisions. It is widely believed that the complex taxation structure in the UK needs to be streamlined and simplified and this has been endorsed by the leading accounting bodies of the UK, including the Institute of Chartered Accountants of England and Wales. "The Institute of Chartered Accountants in England & Wales today (Friday 10 June) called on the DTI to make fundamental changes to outdated capital maintenance rules that impose limits on company distributions. In its response to the Company Law Reform White Paper, the ICAEW argued that the regime is too complex and no longer reflects the needs of companies and their creditors." 8 Bibliography AUERBACH, Alan J. et al. Analysis of Flow of funds. Taxation of companies. Last accessed 15 January 2008 at: http://www.ifs.org.uk/mirrleesreview/presentations/companies.ppt. Calculating net operating income. (2006). [online]. Smart Capitalist.com. Last accessed 11 February 2008 at: http://www.smartcapitalist.com/blog_2.shtml DAMODARAN, Aswath. Finding the Right Financing Mix: The Capital structure Decision. Debt: Summarizing the Trade off. P.20. 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