MM dividend irrelevancy theorem
Except for tax and transaction costs considerations, dividend policy is irrelevant.
Market frictions
Taxes
Transaction costs
Irrelevancy theorem assumptions
- frictionless market (no tax, no TC)
- the investment, financing, operating policies of the firm are held fixed (remember IFO)
Choice between SR and div payout
- under some assumptions -> matter of indifference to shareholders
- under other assumptions it depends on the presence of positive NPV projects for the firm
- positive NPV project = SR
- no positive NPV projects = div payout
Classical tax system
- Double taxation system
:Taxes profits at corporate tax rate and taxes dividend income at personal tax rate
Imputation tax system
Investors who have taxable dividends get a tax credit for taxes paid by the company. This offsets any personal taxes that the investor must pay on dividend income.
Gains associated with SR over cash dividends depends on
- The difference between capital gains tax rate and ordinary income tax rate
- The price the shares were purchased at
- The timing of the sale of shares (sooner = less gain. )
Effects of taxes and TC on distribution policy
Tax
Dividends have tax disadvantages
SR have tax advantages (can be deferred; is lower than div tax rate)
Tax payers prefer SR
TC
Dividends have TC advantage
SR have TC disadvantage (more expensive)
Tax exempt shareholders prefer dividends
Companies that hold shares of other companies prefer dividends (only 30% div is taxable)
How personal taxes affect investment choices
** investors prefer retained earnings over divs if** Expected returns should satisfy:
(1-Tc)(pretax return within corp) > (after personal tax outside corp)
- post tax return within > post tax outside
Whereas investment projects funded with external equity should satisfy:
(1-Tc)(pretax return within corp) > (pretax return outside corp)
- post tax return within > pretax outside
For investors
Retained earnings > dividend payouts or SR (SR= Div in frictionless markets)
