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updated Aug 2013
Imputation Tax Statistics 2014 Australian Market Risk Premium 2013 Reducing the Rate of Company Tax and Eliminating Imputation Tax  
Market Value of Franking Credits Long term trends for ASX yields & risk Government Cost of Capital Understanding WACC formulae and their robustness
       

Valuation errors

(header paper)

Book vs Market Gearing Real vs Nominal values  
Non-existent tax shields Debt tax shield valued at cost of debt  
The Australian Imputation Tax System has undergone major changes over the years.  Under the Simplified Tax System (STS) introduced from 1 July 2002, the franked dividend and credit incomes earned by companies as distributions from other companies have been formally reported and can henceforth be directly observed.  At the same time, a regime for consolidated reporting for corporate groups was introduced.  The financial year 2003 allowed for transition arrangements.  The ATO has had a lot of trouble deciding on the appropriate data for the period 2001-2003.  The past data has been revised numerous times, both up and down.

For the period 2004-2012 company net tax payments were $486 billion.  Some $146 billion was added to the combined Franking Account Balances (FAB) of companies for this period.  This is 30% of the tax payments.  The net credits issued to all shareholders were $337 billion which represents 70% of the company tax paid (according to the FAB data).  This is an estimate for the national access fraction.  ATO financial data also show $321 billion of credits were distributed as fully franked dividends.  Of these, $91 billion were reported as franking credit income by companies.  And of these $91 billion, an estimated $8 billion were received and redeemed by companies within the superannuation businesses of Life Offices, leaving a net $83 billion of credits recycled within companies.  So the net credits distributed by companies were $237 billion and from these $148 billion have been redeemed (including the $8 billion by Life Offices):
  >>   $94 billion redeemed by personal taxpayers
  >>   $42 billion redeemed by super funds
  >>   $4 billion redeemed by charities and other endorsed organisations.

Some 28% of the distributed credits ($89 billion of the gross amount of $321 billion) are not recorded after being issued.  This is approximately the proportion of all Australian equities (both public and private) held by foreigners.  But it also includes any amount not yet filed by domestic taxpayers.

Over the period of 2004-12, the ATO reports that companies had taxable income of $2,008 billion and the ATO determined that they were liable company tax of $486 billion, leaving an after-tax income of $1,522 billion.  From this amount they distributed dividends totaling $840 billion cash and $321 billion of credits (89.1% of dividends were franked, 10.9% were unfranked). The aggregate ATO data imply that the system-wide effective company tax rate was 24.2%, the profit payout ratio as dividends was 55.2% and the distribution fraction of tax as franking credits was 66.0%.  But this effective tax rate is false because it includes franking credits as company income but deducts them as tax offsets before net tax is calculated.  The credit income claimed as a tax offset is 4% of total taxable income of $2,008 billion so the average effective tax rate in Australia is much closer to 28%.

About 62% of distributed credits are redeemed – the redemption proportion of net credits distributed to all shareholders outside of companies as shareholders.  This is the national redemption fraction but it is not a reliable estimate because ...

There is an unreconciled $100 billion of credits difference between tax data, FAB data and financial data for the period 2004 to 2012.  The FAB data ought to be net data as credits paid by one company to another cause a debit in the payer's FAB and a credit in the receiver's FAB, resulting in no net change to the collective FAB.  The dividend data ought to be gross data as companies report their dividend payments regardless of whether or not it is paid to another company (outside of their group).  But the FAB data implies that a net $337 billion of credits were paid and the dividend data is that a gross $321 billion of credits were paid.  Combining these data with the inter-corporate flow of $83 billion results in the unexplained $100 billion of credits.  We explore possible answers to this conundrum.

What is a robust estimate is the national average gamma of 31%.  This is based on the total company tax paid and on the total credit utilisation by taxpayers.  It is not dependent on the interim data of how much is retained in the FAB and how much was distributed as franked dividends.
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The Australian Market Risk Premium has slowly changed over recent decades.  We estimate the MRP using data from 1875 to 2013 but concentrate on the data from 1929 and for this data we estimate the MRP in three different ways.  First as historical averages of differences between market returns and government bond yields (with various sub-analyses such as real vs nominal and averages calculated over time spans of different lengths), then as the dividend discount model applied to historical dividend yields since 1929 (making allowances for the introduction of imputation tax) and finally as forward estimates based on analysts' forecasts of future corporate income.  We demonstrate the simple logic that reconciles the two approaches and indicate the required growth rate to be used in the dividend growth version.

We find broad agreement among all three estimates whereby the MRP gradually declined up to 2005.  Analysts’ implied MRP averaged 5.9% pa prior to the GFC which was very close to the 130 year historical average MRP of 5.7% pa.  During the GFC, implied yields were very high and the commensurate risk premiums were very high.  After the GFC, implied risk premiums temporarily dropped back to 7% pa and then began to climb again.  Our latest implied risk premium estimate is 8.8% as at June 2013.

Historical averages as estimates of the MRP have the perverse property of large and widespread falls in stock prices due to rises in risk aversion, such as the GFC period, cause a decrease in the MRP estimate because the averages now include large negative market returns.  Implied estimates are forward looking and should not suffer from this problem.

We allow for missing return estimates from the S&P/ASX indices due to credits being ignored.  We observe a very highly statistically significant "kink" in the ASX indices pre- and post-imputation (rsq > 99%) and estimate the ASX indices are missing returns of 54 bp per annum due to franking credits which are priced into stocks.  We look for reasons why the MRP might have changed.

 
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Reducing the rate of company tax and eliminating imputation tax.  Of the $486 billion in company tax paid over the period 1 July 2003 to 30 June 2012, $148 billion was utilised by taxpayers as pre-payment of their tax liabilities or redeemed.  Hence, ultimately some 31% of the headline company tax collection was not company tax but a pre-payment of other taxes as Australia has this partly integrated tax system between company tax and personal tax (including retirees on a zero rate and superannuation funds on a 15% rate).  If the rate of company tax was reduced by 31% and imputation tax abolished, then ostensibly the net revenue to government would be unaltered (with a whole lot of caveats about investor behaviour).  There would be major winners and losers from this proposition.  We explore this in a two step process - first cutting the rate company tax from 30% to 21% under the imputation tax system and then the second step of eliminating imputation tax at this 21% rate.  In this manner we can attribute the impacts on the various parties due to each of the two steps.  We first use Telstra Corporation Ltd results for 2014 to demonstrate the two steps in a concrete example and to demonstrate the various data and concepts that need addressing.

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The market average value of a credit = 51% of its face value.  There are three milestones in the life of franking credits; they are created when company tax is paid, they are distributed along with dividends and they are redeemed when shareholders claim them against personal tax liabilities.  When a stock goes ex-dividend it also goes ex-franking credit.  The ex-dividend price of a fully franked stocks falls further than an equivalent unfranked stock.  This gives us a means of estimating the market value of franking credits.  Tax statistics give us the ultimate redemption value of a franking credit. . We estimate the drop-off values across big cap, mid cap and small cap stocks and for dividend yields above and below 2% per event.  The small cap results are unsurprisingly very erratic.  The big cap results give us our estimate of 51% of face value.  We can see no variation in the market value of credits over time but the changes in the company tax rate have changed the amount of credits available per dividend.  
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The Australian stock market index has changed many times over the last 130 years (1875-2004) which reflects the changing composition of the Australian economy. We review the changes over time of the major sectors within the ASX (now S&P/ASX) indices. These changes are also very strongly reflected in the volatility of the indices whereby various waves of volatility have passed through the ASX indices. The last major one corresponded with the rise and decline of the resource sector within the ASX market. The decline in that volatility is still happening today in that we are still experiencing the post-boom decline in volatility. We are seeing a similar decline in GDP volatility, both in Australia and the USA. This hints at a declining future market risk premia.  
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WACC formulae can be dangerous to use in some cases and they remain a mystery to many people.  We introduce a simple logic for describing the various WACC formulae and then we put them to the test for robustness.  There are a couple that should always be avoided because they consistently give under-estimates for valuation.  They also give the widest spread in valuation outcomes so we strongly suggest that these particular WACC formulae not be used in valuation exercises.

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The cost of capital to government is the private sector's pre-tax cost. There is no cheaper capital available to government nor is there any valuation wedge between private and government ownership. Tax equivalent payments, which under government ownership take the form of cash, under private ownership become franking credits, whose market value depends on the pay-out policy of the firm concerned and its ability to distribute franking credits. Government-owned business will make correct investment decisions if they use the private sector post-tax cash flow and the private sector post-tax cost of capital. In this way, they will get consistency with their pre-tax cost of capital and their pre-tax cash flows. As most returns are observed and measured in the post-tax environment, it is preferable to do all the valuations on a post-tax basis as this will avoid making assumptions about converting observed post-tax data into unobservable pre-tax data.
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Errors in valuation calculations are not at all uncommon and some have very large consequences - running into hundreds of millions of dollars! This set of linked papers is a collection of errors we have seen over the years (names of individuals and events withheld). It includes a brief description of each error and example calculations. Contributions (acknowledged or anonymous) are welcome.

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Book vs Market errors occur when a valuation Vanilla WACC valuation is conducted with the debt amount determined by the capital expense (the book value) and not the market value of the asset. These will only be the same when the NPV =0. For NPV > 0 projects, it will erroneously understate the debt amount, understate the debt tax shield and overstate the debt cover ratio.

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Inflation must be taken out of the nominal WACC after forming the nominal costs of capital and then applying the Fisher equation. Errors are made when forming a “real” WACC from real costs of capital. These errors seem more common in the perpetuity valuation of residual or “tail” cash flows that are often implicitly real.

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Tax shields on interest payments must exist before they can have any value. Usually the tax shield on debt interest is readily available and this is consistent with the classical WACC method which values the shield as if it were immediately available. But, if the tax shield on debt is not available for some years due to little or no tax being paid, then the standard WACC approach is in error.

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Debt interest tax shields (ITS) should be valued using the cost of equity, not the cost of debt. The tax shield on debt is a cash flow to shareholders , not debt holders. The note on this issue demonstrates that the value of the ITS is the difference of two values, both calculated using the cost of equity but in the special case of a perpetuity the difference reduces to a debt value capitalised at the cost of debt.

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