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Background

Traditional View. Alternative Views. New View. Background. Are shareholder taxes relevant in pricing equity securities?. Relevant. Irrelevant. What is the impact of these taxes?. The Theory. How do shareholder taxes become impounded into price?. Depends on:.

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Background

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  1. Traditional View Alternative Views New View Background Are shareholder taxes relevant in pricing equity securities? Relevant Irrelevant What is the impact of these taxes?

  2. The Theory How do shareholder taxes become impounded into price? Depends on: • How the firm plans to finance investment • New share issuances • Retained earnings. • How profits are distributed to investors • Dividends • Share repurchases • Liquidating dividends • Secondary market trading

  3. Classic Analysis (e.g., Poterba and Summers (1985) Analysis starts with equilibrium condition: r = (1-td)*Dividend Yield + (1-tg)*Capital Gains This condition used to derive expression for firm value that serves as the basis of firm’s optimization problem. Note: - Partial Equilibrium: r taken as exogenous - For simplicity, certainty is assumed - Ignore debt

  4. Classic Analysis (e.g., Poterba and Summers (1985) Firm chooses investment policy, capital stock, share issuance-repurchase policy, and dividend policy to maximize firm value subject to: 1. Capital stock evolution constraint 2. Cash flow identity 3. Share issuance/repurchase constraint new share issuances  minimal level (assumed negative) 4. Dividends  0 Traditional view: 3 is not binding; 4 is not binding New view: 3 is binding; 4 is not binding

  5. Classic Analysis: Implications from analyzing program NewTraditional Marginal q < 1 i.e.,(1-td)/(1-tg) = 1 Cost of capital r/(1-tc)(1-tg) r /(1-tc)[d(1-td) +(1-d)(1-tg )] Investment policy insensitive totd sensitive to td Dividend policy insensitive to td sensitive to td Price embeds lump sum tax ?

  6. Guenther and Sansing Actually, q/ < 1. Why would corporations exist if q<1 in general? Lower than what? Is there agreement on this?

  7. Guenther and Sansing: Basic Model 1. No optimization; investment/dividend policies assumed. 2. No surprise that price is independent of td. By assuming project returns = r /(1-tc)(1-td), investors are compensated for td via returns, eliminating any price discount to compensate. In world of diminishing returns, if td changes, investment K* would have to change to maintain. 3. Basically an exogenous variation off the traditional view.

  8. Guenther and Sansing: More on Basic Model Can dividend tax capitalization be described as: Pfulltax = (1-td)*Pnotax ? G & S argue: 1. In fact, under the New View: Pfulltax = (1-td)*Pnotax . Why? Recall, under NV investment and dividend policies are insensitive to td. => y would not change with td , only discount embedded in price would change. 2. First, G&S is confusing because they do not have the ingredients of NV here. 3. Second, in contrast to much of the literature, they define r = R(1-td), rather than separating dividend taxes and opportunity costs.

  9. Note that the marginal project earns r/(1-tc) => insensitive to td. For every $1 retained, investors give up (1-td) in dividends. Consider marginal q: $1 of dividends yields $(1-td) $1 invested yields q (or q*(1-tg)) Equating in equilibrium => q = 1-td ( or (1-td)/(1-tg) ) Basically a variant of the New View!

  10. Tax Capitalization: Relative Pricing of Contributed Capital & Retained Earnings??? Assuming tax irrelevance: Pricet = Book Valuet + Et[discounted future residual income] CC + RE Do shareholder taxes => CC + b*RE + Et[Future RI] ? b = 1 => tax irrelevance, traditional view ? b < 1 => tax capitalization (e.g., new view-like)? b > 1 => G&S ?

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