Question

Should the Reduced Tax Rate on Dividends Affect an MNC’s Capital Structure?

POINT: No. The change in the tax law reduces the taxes that investors pay on dividends. It does not change the taxes paid by the MNC. Thus, it should not affect the capital structure of the MNC.

COUNTER-POINT: A dividend income tax reduction may encourage a U.S.-based MNC to offer dividends to its shareholders, or to increase the dividend payment. This strategy reflects an increase in the cash outflows of the MNC. To offset these outflows, the MNC may have to adjust its capital structure. For example, the next time that it raises funds, it may prefer to use equity rather than debt so that it could free up some cash outflows (the outflows to cover dividend would be less than outflows associated with debt).

Which is correct the point or Counter point? Explain.

Answer 1

Point is correct.

At the end of the day dividend is paid post tax. Opting in for a higher equity structure would result in lower net income as youll be losing out on the tax benefits that come with debt. Interest on debt is paid prior to tax payment and hence you get the benefit of a tax shield. For instance assuming a tax rate of 40% on $100,000 you would pay $40,000 in taxes and if you had $20,000 in interest expenses your taxes would reduce to $32,000 resulting in a tax shield of $8,000 which would effectively reduce your cost of debt.

Also, expected return from equity shareholders is usually lower than cost of debt as equity shareholders are risk takers and hence require a higher rate of return to compensate for the risk the endure. Moreoever, paying out heavy dividends would result in a negative signal in most cases as companies usually only pay out when they dont have good avenues to invest that money into implying poor managerial skill or a doubtful future for that industry/sector and this will also lower market price per share resulting in higher trading due to cheaper rates resulting in more stock price volatility.