# Income after taxes of 100 million growing at 5 a year

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income after taxes of \$ 100 million, growing at 5% a year, and that its cost of capital is 10%. Further, assume that this firm has reinvestment needs of \$ 50 million, also growing at 5% a year, and that there are 105 million shares outstanding. Finally, assume that this firm pays out residual cash flows as dividends each year. Free Cash Flow to the Firm = EBIT (1- tax rate) Reinvestment needs = \$ 100 million - \$ 50 million = \$ 50 million Value of the Firm = Free Cash Flow to Firm (1+g) / (WACC - g) = \$ 50 (1.05) / (.10 - .05) = \$ 1050 million Price per share = \$ 1050 million / 105 million = \$ 10.00 Dividend per share = \$ 50 million/105 million = \$ 0.476 Total Value per Share = \$ 10.00 + \$ 0.48 = \$10.476 Long Last doubles dividends Assuming that the firm’s investment policy does not change, this will mean that the firm has to issue \$ 50 million of equity to meet its reinvestment needs: Value of the Firm = \$ 50 (1.05) / (.10 - .05) = \$ 1050 million Value of the Firm for existing stockholders after dividend payment = \$ 1000 million (The remaining \$ 50 million belongs to new stockholders) Price per share = \$ 1000 million / 105 million = \$ 9.523 Dividends per share = \$ 100 million/105 million shares = \$ 0.953 Total Value Per Share = \$ 9.523 + \$0.953 = \$10.476 Long Last eliminates dividends In this case, the firm will accumulate a cash balance of \$ 50 million. The total value of the firm can be estimated as follows: Value of Firm = PV of After-tax Operating CF + Cash Balance = \$ 50 (1.05) / (.10 - .05) + \$ 50 million = \$1100 million Value per share = \$ 1100 million / 105 million shares = \$10.476 Criticisms of MM Theory Dividend irrelevance theory of MM is valid if the perfect market assumptions are satisfied. According to critics, dividend is relevant because of uncertainty of future, imperfections in capital market and existence of taxes. SECOND SCHOOL OF THOUGHT If dividends have a tax disadvantage, Dividends are bad, and increasing dividends will reduce value Radical position Due to differential rates of taxes, tax on capital gains is lower than tax on current income (dividends). So the radicalists argue that the firms should pay as little dividend as they can get away with, so that investors earn more by way of capital gains. Taxation Capital Gains Tax : (Capital assets) Short term capital gains assets held for <= 36 months Long term capital gains assets held for > 36 months Capital Gains Tax : (Securities) ST capital gains assets held for <= 12 months = 15% (+ surcharge) LT capital gains assets held for > 12 months = No Tax Dividend Tax : ( upto 2013-14) = 15% + 10% surcharge + Education cess(2%) + higher edn cess(1%) = 16.995% Dividend Tax : (2014-15 onwards) = 15% + 12% surcharge + Education cess(2%) + higher edn cess(1%) From 2014-15, Dividend Tax is on the Gross amount ( effective rate - 20.358%) From 2016-17, dividends beyond Rs 10 Lakhs will be charged as income in the hands of the shareholder and taxed at 10% Budget 2018 Budget 2018 has proposed to delete Section 10(38) of the Income-tax Act, 1961, which provided for an exemption from tax, the Long Term Capital Gains (LTCG) arising on sale of Equity Shares or Units of an Equity Oriented Mutual Fund on which Securities Transaction Tax (STT) is paid.  #### You've reached the end of your free preview.

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• Fall '19
• Dividend, Dividend yield, equity shares, dividend decision

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