Skip to content

IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

In a market with taxes, Rohan holds shares in two otherwise identical companies. Company P pays out most earnings as dividends. Company Q retains most earnings and reinvests them at the same return. Dividends are taxed at 30% as income, while capital gains are taxed at 10% only when realised. Which conclusion is most consistent with the tax preference theory?

Under tax preference theory, heavier taxation of dividends than of deferred capital gains makes retention more attractive. Q's shares should be valued above P's, or P must offer a higher pre-tax return to give investors the same after-tax return.

  1. ARohan will value P above Q, since dividends are certain and taxed once
  2. BRohan will be indifferent, because investors can offset the tax difference by trading
  3. CRohan's required pre-tax return on P will be lower than on Q
  4. DQ's shares will be valued above P's, or P must offer a higher pre-tax return to compensate investorsCorrect
  5. Dividend policy has no effect on value, because tax rates are the same for all investors in the market

Explanation

If dividends are taxed more heavily than deferred, lower-taxed capital gains, investors prefer retention. Q's shares will therefore command a higher value, or equivalently P must give a higher pre-tax return to offer the same after-tax return. Option 2 reverses this. Option 0 is the bird-in-the-hand view and ignores the tax difference.

Did you get it right without looking?

One question tells you little. A timed set on Capital structure and dividend policy shows your real accuracy, how long you take and where you lose marks.

Practise Capital structure and dividend policyFree diagnostic mock

More Capital structure and dividend policy questions