Capital Gains
To this point, we have assumed that all income is taxed at one rate. Now we assume that a capital gains tax rate of 0.20 applies to capital gains income. This assumes that retention of earnings leads to stock price increases and that these increases can be realized by investors as capital gains.
Returning to the 20-year horizon, with retention and then capital gains taxation of 0.20, the investor would have:
$100 × 1.1020 × (1 – 0.20) = $100 × 6.73 × 0.80 = $538
The cash dividend and an after-tax earning rate of 0.06 again leads to a value of $192 after 20 years.
The net advantage of retention is $538 – $192 = $346. Capital gains taxation increases the value of retention from the $212 obtained above to $346.
Again, if we considered the tax consequences of the dividend decision for all subsequent years, the value of the difference would be even larger. Tax deferral and capital gains are two powerful factors that must be considered in deciding a distribution policy.
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