Capital Structure Decisions - Essay Example

Discuss to what extent the existence of corporate and personal taxes could affect companies dividend policy and capital structure decisions. Table of Contents 1. Introduction 2. Dividend Policies and Capital Structure 3. A review of the Modigliani-Miller (MM) theory in relation to dividends and capital structure decisions 4. Impacts of tax reforms 5. The way ahead for the tax effect debate 6. Conclusion 7. References Introduction Over the last half a century academics have spoken in great depth over the issue of corporate and personal taxes affecting a company’s dividend policy and have suggested conflicting theoretical frameworks to explain their point of view.(Frankfurter 2002).The problem is that these assertions often lack empirical depth to the criticism and stumble upon self contradictions in an attempt to explain corporate dividend behaviour.(Frankfurter 2002).Today academic opinion is divided as to whether dividends are attractive to shareholders and will have a positive impact on stock prices.(Frankfurter 2002 )Another school of thought contends that prices are negatively correlated with dividend payout levels.(Frankfurter 2002).The third view is that firm dividend policy is irrelevant in stock price valuation. (Frankfurter 2002.These views are best summed up as being based upon, the tax effect ( Litzenberger and Ramaswamy (1980),)Clientele effects explanations (Elton and Gruber, 1970), Agency theory explanations(Easterbrook 1984), Signaling models(John and Williams (1985), and psychological/sociological explanations ( Frankfurter and Lane 1992). Coming to the aspect of Dividend Policies, Capital structure decisions and taxation academic literature has similarly differed and presented varying views. The leading theory here is the MM theory discussed below based on which the paper explores the literature pertaining to the simultaneous effect of both the corporation tax and personal income taxes on the dividend policy and capital structure of a firm in theory. In this vein many other studies have also examined the temporal pattern of corporate dividend payout and dynamic dividend behavior based on varying tax codes.(MA Lasfer 1996). It has been seen often that there will be “ structural shifts in the aggregate dividend payout and these shifts often coincide with tax law changes”(Wu 1996).Thus the empirical evidence on the effects of both corporation and personal income taxes on dividend payment adjustments and on capital structure decisions is accordingly reviewed hereafter. Dividend Policies and Capital Structure It has often been stated that companies set their dividend policies to minimize their tax liability and to maximize the after-tax return of their shareholders. (Wu 1996).It has also been stated that whenever a company is unable to deduct the advanced corporate tax from their tax liability it will resort to giving out low dividends.(Wu 1996 citing Brennan). The notion of the tax hypothesis states that the differential taxation of dividends and capital gains results will tend to decrease the share prices .Academic opinion suggests that if the classical system is abandoned and the imputation system is followed then the overall tax burden on dividends for the shareholders will be inversely proportional to the firms payout ratio when the tax credit is recoverable and shareholders are tax-exempt or taxed at the standard rate of income tax. When this money is not recoverable then this burden will increase on dividends. (Wu 1996). What has to be seen here the understanding of this concept in the matter of the challenge it poses to the dividend irrelevance proposition. Research has shown that that dividends will inevitably lag behind in earnings, and might become sticky (that is firms will be unlikely to vary them) and will avoid cutting them even when things are not so good with the firms. (Wu 1996).Dividend policies will tend to waver over the life span of the firm based upon the local tax laws, growth rates, cash flows, and project availability. It is also an assumption and to a large extent true that earnings and dividends are positively related since dividends are paid out of earnings. (Frankfurter 2002).According to John Linter writing in the mid-fifties there are a few constant patterns to dividend policies that is that firms will set target dividend payment ratios, by deciding on the what they are willing to pay in the long term and secondly whether they change dividends to match the long-term and sustainable shifts in earnings, Finally that the management will be more concerned about dividend levels rather than change or variations in them. At the same time Fama and Babiak have observed a lag between earnings and dividends and capital structure decisions , by regressing changes in dividends against changes in earnings in both current and prior periods and have agreed with the views of Lintner .It can also be gleaned from academic theories that firms will be reluctant to raise tax dividends and these will follow a much stable path than earnings themselves. (Frankfurter 2002).The firms tax policy of dividends is also related here as the five stages in the growth life cycle (that is tart up, rapid expansion, high growth, mature growth and decline.) are all reflected through the dividend decisions. The proposition thus presents a valid point in the sense as to what Miller Modigliani (The MM theory) called Dividend irrelevance policy where some kinds of firms remain unaffected by dividend decisions that is those types which are small companies with substantial investment needs or large companies with significant insider holdings and significant holdings by pension funds (which are tax exempt) and minimal investment needs. A review of the Modigliani-Miller (MM) theory in relation to dividends and capital structure decisions This theory has had some interesting contributions to the effects of taxation on dividend policy and capital structure decisions and is based upon the works of Modigliani & Miller (hereafter MM) in their relevant papers published quite a few decades ago.(1958,1963,1966).These papers remain the main literature even today pertaining to the capital structure and cost of capital theories. This theory assumes that in a hypothetical situation with perfect capital markets, rational investor behavior, no tax differentials, and no bankruptcy costs , The firm value/Capital structure can be explained as (Modigliani-Miller 1963) VL = VU + tauD = (l - tau)E(X)/ rho + tauR / r 1 Furthermore based on Fama’s explanation (Fama 1968) the after tax return earnings after interest and taxes, plus interest represented as Xtau, can be expressed as: xtau = (l - tau)(X- R) + R = (l - tau)X + tauR. MM (1963) further state that for the investor the long-run after tax returns appear as a sum of two components: an uncertain stream, (1- tau)X, and a sure stream, tauR. This leads us to the conclusion that the equilibrium market value of these two combined can be evaluated by capitalizing each component in a separate manner. Now if we scrutinize this model the problem comes with the presence of taxes or the lack thereof. For example if we state the cost of equity capital to be i*, ( rate of return required on a firms equity by the market) when fitted into the MM framework, i* would be stated as follows E(Xtau) - tauR = (l- tau)E(X). Thus we can state that VL = E(Xtau) - tauR / rho + tauD = E(Xtau - taurD + rhotauD (divided by )rho= E(Xtau) + tau(rho - r)D / rho. Xtau can be expressed as the net profit after interest and taxes accruing to investors Thus after reducing from earnings before interest and taxes, (EBIT), X, the amounts of taxes, (X-R)tau, and interest charges, R, yields the net profit, pi, which belongs to the shareholders we would have the following situation as stated in Miller (1966) pi = X- (X - R)tau- R = (l- tau)(X - R) The expected profit size according to Modigliani (1958) becomes E(pi) = (l- tau)[E(X) - R]. Therefore the value of the firm/capital becomes according to Modigliani (1963) as VL = E(pi) + rD + tau(rho - r)D / rho With the value of the equity being S=VL - D= E(pi) + rD + tau(rho - r)D - rhoD / rho = E(pi) -(l-tau)(rho - r)D / rho 2 All this shows that i* or the Required rate of return determines S itself and thus the value of the equity can now be rewritten as S = VL - D =(l - tau)E(X) . rho + tauR / r - R / r = (l - tau)E(X) / rho - (l - tau)R / r. Furthermore the MM thesis while taking into account the net profits to common shareholders after interest and taxes, E(pi) = (l- tau)(E(X) - R) and assuming a ZERO tax rate (tau=0) and then an assumed 50 percent Tau =50 for example can show us what MM state that in the absence of taxes, the value of the firm (V) will not be dependant on leverage. However wherever there will be taxes the value of the firm will increase due to the tax saving incentives.Based on the introduction of taxes will not prima facie cause variations in the rates of return for stockholders given that this leverage is measure in terms of total earnings and interest payments but ‘not” market values.Thus i* will not be affected but the tax shield will nevertheless increase the value of the firm with taxation. The problem begins when we note that in the MM model the investor has limited liability and is not therefore responsible for firms losses in a situation of bankruptcy. The MM theory further argues in Miller and Modigliani (1961) that dividend policy is irrelevant for the cost of capital and the value of the firm if a situation is assumed devoid of taxes or transaction costs.Thus the investors will be able to have varying income patterns and the dividend packages will be irrelevant in inducing them to buy shares and the firms will be free to choose any payout pattern without affecting their value. The MM theory stipulates that the firms investment and financing decisions will thus in such given conditions not be uniform over a period of time. The graphs below show how we can frame capital structure with in the MM theorem, where as equity can be realized as a call on the firm and the creditors will have priority over shareholders.Thus the pay offs to creditors and the shareholders would look like the following where as the value of the firm surpasses the required debt payment and at this point only the shareholder will get their payoff. Impacts of tax reforms It can also be seen that the impacts of tax reforms on the pattern of corporate dividend payout and dynamic dividend behavior. Many studies have emphasized on the individuals’ tax reduction strategies based on dividends and taxes that emphasize upon individuals’ tax reduction strategies (Miller & Scholes, 1978).On the one hand Miller and Modigliani (1961) have argued dividend policy is irrelevant for the cost of capital and the value of the firm in a world given that a hypothetical world without taxes is imagined devoid of taxes or transaction costs. This view has (as discussed above)suggested that when investors can create any income pattern by selling and buying shares, the expected return of the shares required to induce the shareholders to hold firm shares will be invariant to the way the firm offers dividend payments and new issues of stocks.They state that the assets, investment opportunities,and the future net cash flows and cost of capital are not affected by the choice of dividend policy.This applies to the market value of the assets being unaffected by any change in the dividend.Thus, dividend policy is irrelevant to tax returns. Miller and Modigliani’s (MM) theory implies that dividend policy will fluctuate as a side effect of the firm’s investment and financing decisions, and therefore it will not manifest itself in the investment pattern.Again the tax irrelevance argument applies here but mostly corporate taxes but personal taxes. However the situation is complicated in the matter of personal taxes where as in the matter of corporate taxes there are no transaction costs and investment decisions are independent of dividend decisions this is not the case for personal taxes.As mentioned above this becomes a relevant concern where as the investors dividend income tax rates are greater than their capital gains tax rates.This view however ignores the fact that many times the investors will be able to use tax loopholes to shelter their income through tax-exempt and tax-deferred investments.It should also be noted that in case of personal taxes whenever there is a reduction of the tax liability of dividend income there will be an involvement of transaction costs which may preclude investors from fully using tax-reduction strategies.Nevertheless tax dividends will generally mean for individual investors a higher income tax rate than capital gains tax.. So in the case of personal taxes the dividend policy may affect their after-tax income and thus add to capital costs and firm value.It has been said by Brennan (1970) as cited by Wu (1996) that the higher the risk the higher the total return on security and the higher will be its prospective yield in dividends which means that a higher tax rate will be levied on dividends than on capital gains. This leads us to conclude that firms will have to in order increase the individuals net after tax income pay smaller cash dividends to them to decrease their burdens.This also leads us to the hypothesis that given that the taxes are relevant to the firm’s value and cost of capital, there should be a change in the corporate dividend policy if there is a change in personal income and/or capital gains taxes. As mentioned above , a perusal of the literature will often show that taxes will tend to affect corporate dividend policy (Farrar & Selwyn,1969 Brennan, 1970; Masulis & Trueman, 1988 cited by Wu 1996).Based on this Wu (1996) has suggested that the changes in corporate dividend payout should be observed whenever the government changes its income tax policy. The other view comes from Miller and Scholes (1978, 1982) who have shown that dividend income could, to a large extent, be sheltered from taxation. Therefore, the effect of taxes on corporate dividend policy depends on the extent to which individuals can elude taxes.This would mean that the firms and the investors would be expected to react to the tax regulations and changes in tax regimes as WU (1996) noting the MM theory states that ‘ Firms and investors are expected to respond to the change in the tax code in making their dividend and investment decisions. For instance, when there is a decrease in the capital gains tax rate relative to the regular income tax rate, firms should reduce their dividend payout, and vice versa.’ (Wu 1996). To explain this Wu (1996) has set out the following hypothesis which explains the changes in tax laws on corporate dividend policy by analyzing the shareholders’ after-tax income under differential taxes. This model assumes that there is an existence of corporate and personal debts and there are differing tax rates for capital gains and dividends.Furthermore it is assumed also that the firm will have positive after tax income and the firm and shareholder enjoy an equalized borrowing rate. Thus this should bring us to the following equation Yd = [(Y - iD,)( 1 - tJ - iD,](l - t&J) (Wu 1996) Where as Yd is the shareholder’s after-tax income given that the corporate income is distributed totally as dividends Y = the firm’s net operating income i = the borrowing rate tc = the corporate income tax rate tp = the personal income tax rate D, = corporate debt, and Dp = personal debt. Wu (1996) also considers the scenario where as the firm does not pay dividends to let the shareholder realize capital gains which can be seen in the equation below. F = (Y- iD,)(l - t,)(l - tg) - iD(l - tp) (Wu 1996) Where as F = the shareholder’s after-tax income if the firm does not pay dividends and tg = the shareholder’s capital gains tax rate. It can be noticed here that the shareholder’s after-tax income will be bigger than when the firm pays no dividends and the capital gains tax rate will be lower than the regular income tax rate.(Wu 1996).Furthermore it can be seen from this model that an increase in the capital gains tax rate will not only be relative to the regular income tax rate,it will also reduce the dividend yields.Also it can be seen that the capital gains tax rate relative to the regular income tax rate should affect the corporate dividend payout if we are to rely on the tax dividend theory. The way ahead for the tax effect debate The relevance/irrelevance dilemma is a matter of great academic importance here.The dilemma of whether to return cash to its stockholders and if so how much in the form of dividends haunts every private and public company owner. Many schools of thought have taken conflicting views on this issue. The “ dividend irrelevance” group of thought will reveal that dividends have nothing to do with firm value because there is no tax disadvantage to an investor to receiving dividends, and that firms can raise funds in capital markets for new investments without having to go through high issuance costs. Another school of thought believes that dividends are adverse for the average shareholder as they attract taxes and cause fiscal disadvantages. Last but not the least the third group lauds large dividends as positive signal to shareholders that all is well. (MA.Lasfer 1996) Furthermore despite an over lack of empirical evidence to support this there is little or conflicting evidence to support the proposition that the corporate and personal income taxes are expected to affect firms dividend payout ratios, its subsequent share price movements and the composition of its shareholders.3 However what is also true is that a review of the academic opinion suggests that no economic rationale can actually be given to explain the tax dividend phenomena unless an attempt is made to review this from the perspective of agency costs and shareholder signaling. (Frankfurter 2002). Also a review of the literature has also sufficed to show that in determining a Tax dividend policy it is important not to be swayed by the “The Bird-in-the-Hand Fallacy” which states that investors will prefer dividends to capital gains based on their certainty or that high dividend rates are a consequence of firms are tempted to pay or initiate dividends in years in which their operations generate excess cash.Relating to taxation effects generally it has often been stated that there is an overall lack of tax analysis that can explain the cross-sectional or time-series variations in dividend payments made by individual companies. The tax burden on the dividends originates from both corporate and personal income tax systems where as the total of the taxes comes from the sum of the corporation tax plus the effective capital gains tax and the tax on dividends.Many times the tax on dividends will exceed the gains which might be a reason to reduce the dividends.(MA Lasfer 1996).However in another setting like the imputation system the total tax is computed by the corporation tax plus the effective gains tax plus the reduced dividend tax. (Wu 1996).Thus an incentive to increase dividends will be created when the reduction in the tax on dividend is big enough to make decreased dividend tax lower than the effective capital gains tax.All these issues have been duly reviewed above and their relevant complications have been discussed. Conclusion In this paper we have reviewed a number of phenomena’s relating to the effect of personal and corporate taxation upon a firm’s dividend policy and it has been seen that the MM theory applies to the case of corporate taxes but not personal taxes. Capital Structure decisions of the value of firms with or without debts are thus not likely to be affected by dividend policy if there is no consideration (hypothetically) of transaction costs and thus capital structure decisions will become independent of dividend decisions. Personal taxes are however a different story and here the dividend policy becomes relevant only if investors dividend income tax rates are higher than their capital gains tax rates.This does not take into account the legal framework with in which the regime operates.Furthermore it has also been noted that the reduction of the tax liability of dividend income will often come to involve transaction costs.Thus the presence of these transaction costs will stop investors from full utilizing tax reduction strategies.These complications will then mean that the individual investors would still subject individual investors to a higher income tax rate than capital gains do.Based on this it was seen that dividend policy may affect investors after-tax income and therefore, the cost of capital and the value of the firm and finally have a bearing on its capital structure decisions. References MA. 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Dividend policy: a review ,Asper School of Business, University of Manitoba, Winnipeg Managerial Finance ,Volume 33 Number 1 2007 pp. 4-13 ,Emerald Group Publishing Limited ISSN 0307-4358 Read More