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Exhibit 18.10 Approaches to Taxation of Dividends

Country How are dividends taxed?

Australia Dividend imputation

Belgium Classical tax (double taxation)

Denmark Classical tax with lower personal tax rates on dividends

Finland Dividend imputation

France Dividend imputation

Germany1 Dividend imputation

Italy Dividend imputation

Netherlands Classical lax (double taxation) Norway Dividend imputation

Portugal Dividend imputation

Spain Dividend imputation

Sweden Classical tax (double taxation)

Switzerland Classical tax (double taxation) united Kingdom2 classical tax (double taxation) 1 Tlif German government proposed sigmiiraiM changes ro its Iax rode 1 United kingdom had a dividend imputation system until 1999. Source: European Tax Handbook, 1997; Fmoncial Times

If there is dividend imputation, what is the (a* credit rate on net dividends?

Full imputation.

7/18 tax credit on netdividends(full imputation o( 28% corporation tax),

Tax credit of 50% ort net dividends (full imputation of basic 33% corporate lax rale, bui excludes 10% corporate tax surcharge).

Tax credit of 1/7 of the net dividend (full imputation of 30% corporate tax on dividends). Note that taxes on retained earnings are 45%, while on dividends they are 30J6.

Tax credit of 56.25% of net dividend (almost full imputation <it 17% corporate tax).

Dividend imputation equivalent to tax credit on net dividends of 7/18 (full refund of corporate tax at 28%) for resident shareholders. The lax credit is implicit rather than explicit, since dividends are considered tax-tree

Partial imputation with a 33.75W tax credit on net dividends (a refund of 60% ol ihe 16% corporate tax rate).

Partial imputation: Resident individuals receive 40% tax credit on net dividends; resident corporations receive 27% (50% refu nd o! corporate tax at 35%).

n early 20011, including criminating the dividend ta» credit.

value of the company: in choosing how much of retained earnings to distribute as dividends, management also determines how much of the potential tax credit shareholders will receive.

How to deal with dividend imputation in valuations is controversial. The debate centers on whether personal tax credits should be taken into consideration in the valuation. As a practical matter, dividend imputation may be irrelevant if the key stock price-setting investors are institutional investors or foreign investors who do not benefit from the dividend tax credit. One approach effectively says that no adjustments should be made to the cash flows or discount rate of companies in countries with dividend imputation. An alternative approach includes the impact of dividend imputation by adjusting the company's cash flows to take into account the dividend tax credit. Here are the steps to follow:

• Size of tax credit. The tax credit is equal to the amount of dividend paid in the year multiplied by the tax credit rate on net dividends. The relation between the corporate tax rate (tc ) and the tax credit rate on net dividends (t, ) for countries with full imputation is:

For countries without full imputation, the government defines the tax credit rate (as shown in the Italian example in Exhibit 18.9).

• NOPLAT. As part of the calculation of taxes on EBIT, subtract the tax credit from the income tax provision in the income statement. When NOPLAT is calculated starting from net income, the tax credit should be added back to net income. See Exhibit 18.11 for an example.

• Cash flows. There is no need to change the calculation of free cash flow, since the tax credit has already been included in NOPLAT. In the financing flows, include the tax credit on cash dividends paid out. Even though the government pays this, not the company, it should be included to accurately represent the actual cash flow to the shareholder before individual taxation.

• Cost of capital. No changes in the WACC formula are necessary. Exhibit 18.11 Impact on NOPLAT of Dividend Imputation

Exhibit 18.12 Effect of Changes in Dividend Payout Ration on Valuation

When dividend imputation is included in a valuation model, the dividend payout ratio can have a significant effect on value. The effects of changing the payout ratio in one model are shown in Exhibit 18.12. Where dividend imputation is not present, dividend policy has no impact on value. Where imputation is used, all other factors being equal, the higher the payout ratio, the higher the value of the firm.

Cost of Capital

The basic approach for estimating the weighted average cost of capital is identical to that described in Chapter 10. The weighted average cost of capital for a company is a weighted average of the costs of its equity, debt, and other financing sources. The cost of capital should be consistent with and expressed in the same currency as the cash flows being discounted.

Most of the components of the cost of capital do not require special discussion here. For example, it is common practice around the world to use the CAPM for estimating the cost of equity. Two issues merit detailed discussion: what market risk premium and beta to use.

As in the United States, the choice of market risk premium is vexing. For countries that are developed and reasonably integrated into the global capital market, we favor using a worldwide risk premium, based on the U.S. risk premium of 4.5 percent to 5 percent.

Our reasoning is based on the globalization of capital markets. In the late 1990s, about 25 percent of all equity trades were considered international—in other words, the shareholder and the company were domiciled in different countries. These global traders, primarily large institutional investors, draw their capital from and invest it all over the world. If expected premiums were significantly different across countries (on a risk-adjusted basis), you would expect to see significant flows to countries with higher-than-average premiums and away from lower-than-average premiums. Such a movement would tend to reequalize premiums.

This makes intuitive sense. Consider the consumer goods companies Procter & Gamble and Unilever. Both sell their household products globally with roughly the same geographic spread. The shares of both are traded in

Exhibit 18.13 Measured Risk Premiums Vary Widely

Percent

Full measurement period1

United Kingdom (1919) United States (1926) Sweden (1937) France (1949) Netherlands (1956) Germany (1967) Germany (1954-33) Italy (1960) Belgium (1949)

Full measurement period1

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