Saturday, February 18, 2012

Obama's budget and finance's M&M theorem

One of the notable changes in the President’s entirely symbolic budget is the proposed adjustment in tax on dividends from the current capital gains rate of 15% to the personal rate of 39.6% for those with incomes above $250,000.  It should be noted that this is a change of 24.6 percentage points, and perhaps more revealingly, a 164% percent change.  Without knowing how the expected revenues from this change were derived I’d feel very confident in the prediction that actual revenues will be less.  Change something by more than 100% for people who have financial means, and you are likely to get rather dramatic changes in behavior.

Which brings me to one of the central tenets of modern finance; the M&M or Modigliani-Miller, theorem.  What M&M posits is that in absence of taxes and bankruptcy costs, capital structure—that is a company’s mix between equity and debt—doesn’t matter.  Bankruptcy costs obviously tilt the field towards equity since debt costs are a financial, legal obligation. 

Taxes enter into it because interest expense is a deductible expense for the corporation.  The money going to debt holders is before tax, the money in the form of dividends to equity holders is after tax.  And here it is worth bringing up a point made by finance professor Harold Bierman: “if a company is 100% debt financed, the debt holders own the company.”  In other words, the distinction between debt and equity isn’t as concrete, as absolute as it would appear on first thought.  What, for example, is a convertible bond?  Thus, following M&M you have investors who put money into a company in the expectation of a financial return, absent the conditions discussed, they and the company proper are indifferent whether that is in the form of debt or equity.

So what does all of this have to do with the change in dividend rates?  Well financial returns are always calculated as after tax cash flows and it should be noted that the value of a stock is, at least theoretically, the discounted value of future dividends [the capital gains benefit derives from your selling the right to a future cash flow stream, i.e. the future dividends].  Increase the tax on dividends and you’ve made it more attractive to invest via debt rather than as a shareholder.  Further, by reducing the benefit of receiving dividends you’ve increased the benefit of the company holding on to and using cash rather than distributing its profits.  In short, the financial implications of the change in dividend treatment being proposed by a Democratic administration is a tilt towards greater debt finance, and larger companies!

One final, relevant point: when a company engages in a stock buy back it is often derided in the press as an action to prop up the stock price.  While reducing the number of shares will have the effect of raising the share price—the same pie being divided into fewer slices equals larger portions—that isn’t really what is going on.  A stock buy back is just another method open to a company to distribute money back to investors, with the advantage of being able to delineate who wants to receive those funds and who doesn’t at a certain time (as opposed to a dividend which goes out to every shareholder), and to distinguish between equity holders in different tax situations.  A significant increase in the tax rate on dividends should lead to more companies opting to buy back shares, a kind of dividend masquerading as a capital gain.

No comments:

Post a Comment