Relationship between franking credits and the market risk premium: a reply

Abstract

We have previously documented an inconsistency between the dividend yield implied by the Officer (1994) model with standard Australian regulatory parameters and actual dividend yields of Australian companies. We have shown that, within the Officer framework, this inconsistency can be resolved by setting the assumed value of franking credits (&ggr;) to zero, consistent with the practice of Australian firms and independent valuation experts. Truong and Partington (2008) and Lally (2008) recognize this same inconsistency and propose alternate ways of resolving it. In this paper, we demonstrate that these proposals are outside the Officer framework. The standard set of regulatory parameters cannot be resolved with observed dividend yields within the Officer framework. Whichever method is used to resolve the inconsistency, the effect will be an increase in the estimated after-tax cost of equity. Copyright (c) The Authors.

Fifty years of finance research in the Asia Pacific Basin

“…The issue of dividend imputation and its relevance to cost of capital computations is raised by Officer (, ), Wood (), Truong et al . (), Gray and Hall (), Dempsey and Partington (), Truong and Partington (), Lally (), Gray and Hall () and Chu and Partington (). The primary issue here is the value of dividend imputation tax credits and its relevance to cost of capital computation.…”

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“…eliminating double taxation). 7 Shareholders thus receive a gross dividend (𝐺𝐷) comprising the cash distribution (𝐶𝐷) and a franking credit (𝐹), the latter representing the value of corporate taxes paid (𝜏 𝑐 ) 𝑤ith 𝑥 representing the percentage of the cash dividends paid from post-tax profits (Beggs and Skeels, 2006;Gray and Hall, 2008;Fenech, Skully and Xuguang, 2014).…”

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“…The CAPM has become the ‘industry standard’ for regulatory decisions on the cost of capital and price determination for utilities (see Romano, , for U.S. and Grayburn et al ., , for U.K. evidence). Gray and Hall (, ) refer to more than 10 Australian bodies that regulate infrastructure assets, worth more than $A100bn in total, where those assets were acquired after evaluation using CAPM‐derived cost of capital estimates.…”