Introductory Corporate Finance: Dividend Policy - Tax Preference Theory, Dividends Taxed More than Capital Gains Implications for Payout Policy

What This Is

Tax Preference Theory (TPT) explains how the tax system affects a firm's payout policy. It states that dividends are taxed more heavily than capital gains, making it more beneficial for shareholders to receive capital gains rather than dividends. This theory has significant implications for corporate finance, as it affects a firm's decision on how to distribute profits to shareholders. For example, consider a company like Apple, which has a significant amount of retained earnings. According to TPT, Apple may prefer to distribute its profits through share repurchases or capital gains rather than paying dividends, as this would result in lower tax liabilities for its shareholders.

Key Formulas & Models

• TPT = (1 - ?d) / (1 - ?c) – Tax Preference Theory ratio; measures the relative tax burden on dividends vs capital gains.
  • ?d: dividend tax rate
  • ?c: capital gains tax rate
• DPS = (1 - ?d) × EPS – Dividend per share; takes into account the tax preference for capital gains.
  • DPS: dividend per share
  • EPS: earnings per share
• CGS = (1 - ?c) × EPS – Capital gains per share; reflects the tax preference for capital gains.
  • CGS: capital gains per share
• TPT Ratio = (1 - ?d) / (1 - ?c) – Tax Preference Theory ratio; measures the relative tax burden on dividends vs capital gains.
• ?d = 0.4 – Dividend tax rate; assumes a 40% tax rate on dividends.
• ?c = 0.2 – Capital gains tax rate; assumes a 20% tax rate on capital gains.
• EPS = $10 – Earnings per share; assumes a $10 EPS.
• DPS = (1 - 0.4) × $10 – Dividend per share; calculates the dividend per share, taking into account the tax preference for capital gains.
• CGS = (1 - 0.2) × $10 – Capital gains per share; calculates the capital gains per share, reflecting the tax preference for capital gains.

Step-by-Step Calculation

1. Calculate the tax preference ratio using the TPT formula: TPT = (1 - ?d) / (1 - ?c).
2. Determine the dividend per share (DPS) using the formula: DPS = (1 - ?d) × EPS.
3. Calculate the capital gains per share (CGS) using the formula: CGS = (1 - ?c) × EPS.
4. Compare the DPS and CGS to determine the relative tax burden on dividends vs capital gains.
5. Consider the implications of TPT on a firm's payout policy, including the potential for share repurchases or capital gains distributions.

Common Mistakes

• Mistake: Ignoring the tax preference for capital gains when calculating DPS.
• Correction: Use the TPT formula to calculate the tax preference ratio and adjust the DPS calculation accordingly.
• Example: If the tax preference ratio is 0.6, the DPS would be 0.6 × $10 = $6, rather than the incorrect $10.
• Mistake: Assuming the tax rates on dividends and capital gains are equal.
• Correction: Use the correct tax rates for dividends and capital gains, which are typically different.
• Example: If the dividend tax rate is 40% and the capital gains tax rate is 20%, the TPT ratio would be (1 - 0.4) / (1 - 0.2) = 0.6.

Exam / CFA Tips

• Tip: Be prepared to calculate the TPT ratio and adjust the DPS calculation accordingly.
• Tip: Understand the implications of TPT on a firm's payout policy, including the potential for share repurchases or capital gains distributions.
• Tip: Be aware of the differences between the M&M Proposition I (no taxes) and the TPT, which takes into account the tax system.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, and tax 25%. Calculate the degree of financial leverage (DFL) using the formula: DFL = (1 + (1 - ?) × r) / (1 + r).

Answer: DFL = (1 + (1 - 0.25) × 0.1) / (1 + 0.1) = 1.05 / 1.1 = 0.955.

Explanation: The DFL measures the sensitivity of EBIT to changes in sales. In this case, the DFL is 0.955, indicating that a 1% change in sales would result in a 0.955% change in EBIT.

Last-Minute Cram Sheet

• TPT = (1 - ?d) / (1 - ?c) – Tax Preference Theory ratio; measures the relative tax burden on dividends vs capital gains.
• DPS = (1 - ?d) × EPS – Dividend per share; takes into account the tax preference for capital gains.
• CGS = (1 - ?c) × EPS – Capital gains per share; reflects the tax preference for capital gains.
• ?d = 0.4 – Dividend tax rate; assumes a 40% tax rate on dividends.
• ?c = 0.2 – Capital gains tax rate; assumes a 20% tax rate on capital gains.
• EPS = $10 – Earnings per share; assumes a $10 EPS.
• DPS = (1 - 0.4) × $10 – Dividend per share; calculates the dividend per share, taking into account the tax preference for capital gains.
• CGS = (1 - 0.2) × $10 – Capital gains per share; calculates the capital gains per share, reflecting the tax preference for capital gains.
• TPT Ratio = (1 - ?d) / (1 - ?c) – Tax Preference Theory ratio; measures the relative tax burden on dividends vs capital gains.
• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.