Comprehensive Literature Review on Franking Credits and Market Value

This literature review examines franking credits and dividends, particularly within the Australian context, focusing on their market value and methods of estimation. It explores the concept of dividend imputation, where tax credits are provided to prevent double taxation of corporate dividends, and analyzes how these credits influence tax obligations and investment decisions. The review synthesizes the viewpoints of various authors, concluding that franking credits prevent "double dipping" and that their market value can be estimated using Gamma in the Weighted Average Cost of Capital (WACC) and Dividend Drop Off studies. The document covers the overview of franking credits, categories (immediate, stockpiled, and future), and the methods to evaluate its market value. It highlights that the value placed on franking credits by investors varies, affecting the required rate of return, and that international investors may not fully benefit from these credits. The review uses various sources to analyze the market value and estimation techniques for franking credits and dividends.

Literature Review
The market value of franking credits and methods of estimating

ABSTRACT
Dividend imputation credit is from of tax credit provided to taxpayer to avoid double taxation of
corporate dividends. These credits can be fully or partially franked in nature and can have a
significant impact on tax obligations and investment decision of the taxpayers. By considering
the significance of the topic, the study evaluates franking credits and dividends and its market
value by studying the viewpoint of various authors. The study concludes that franking credit is
introduced to prevent “double dipping” through the government as tax cannot be charged on
profits on which dividend is already paid by companies. Further computation of the market
value of dividend and its franking credit can be done by Gamma applied in the Weighted
Average Cost of Capital and Dividend Drop Off.

Table of Contents
Introduction......................................................................................................................................1
Overview on franking credits......................................................................................................1
Categories of flaking credits........................................................................................................2
Market value of franking credits..................................................................................................3
Methods of estimating.................................................................................................................4
Conclusion.......................................................................................................................................5
References........................................................................................................................................6

Introduction
The present report aims at conducting a literature review on franking credits in which the
findings of various authors have been extracted on the relevant topics of franking credits, that is
dividend’s market value, in the Australian context.
Overview of franking credits and dividend
In Australia, companies have to pay a flat of 30% tax on all revenues. Nevertheless, if any
company is not forced to pay tax on any revenue or profit, then is allocated to shareholders in the
form of a dividend. Thus, when the dividend payment is received by investors, it may either fully
frank, partially franked or unfranked. Fully franked are those 30% tax previously paid prior then
the dividend received by investors, Partly franked are those on which 30% tax has previously
paid on the “Part” of dividend, and Unfranked are on which the tax has not paid. The amount of
franking is displayed as a per cent; a partly franked signify that the company already paid tax on
75% of dividend at the tax rate of 30%, but not on remaining 25% (Market index, 2018).
The same as shareholders all have a diverse marginal tax rate;it is used by franking credits to
computing that what of tax is obliged on the shareholder to have been payable during the at
financial year-end. In 1987, the ‘double dipping’ was stopped with the opening of Imputation
System.; however, in this system, dividends accompany franking credits (imputation costs)
affixed which shows that the company previously paid tax. If an investor is qualified to make use
of franking credits then at the end of the financial year their tax liability is decreased. The excess
of franking credits may possibly guide to repayment while the marginal tax rate of investor is
lower than the corporate tax rate of the percentage 30 (Market index, 2018).
The major reason for the imputation tax system is to evade corporate profits that are taxed two
times. In the imputation tax system of Australia, dividend associated with a franking credit is
assigned to the taxpayer to counterbalance the individual taxation liability. Further the concept of
franking credit individual taxation that was previously payable at the corporate level. In
accordance with the study of Swan (2018) Australian face value of imputation credits is 1$ each
credit that may be asserted as a rebate for counterbalancing individual tax liabilities (Swan,
2018). From 1 July in the year 2000, a repayment on any extra credits more than individual tax
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liabilities can be asserted. Therefore, it is essential to the reminder that the imputation tax credit
is used by international investors. Therefore, imputation tax credits give benefit only to
Australian investors.
Categories of flaking credits
 Immediate franking credits- franking credit attached with the dividend paid immediately.
 Stockpiled franking credits- the reasonably structured can be discharged,i.e. buy-back of
shares, a special dividend.
 Future franking credits- those credits that do not presently exist but it will produce in
future by the use of future tax payments.
Firstly, an Immediate franking credit- its value can be a monitor on stock markets. In this, the
concept of dividend drop-off studies analyze the alterations in the trading price of listed stocks in
the region of the ex-dividend trading dates (McClure et al., 2018). In the previous investigations,
it was observed that the value between 35% and 74% of franking credit (theta) is valued inside
stoke with the help of the market. In stockpiled franking credits, the release’s time of stockpiled
franking credit is uncertain (Toth and Burns, 2016;Swan, 2018;Market index, 2018;Beggs and
Skeels, 2006).There are two major methods releasing the stockpiled franking credit to their
investors, are as follows- the first method is a special dividend, and the other is off-market share
buy-back. In global financial crises, latter was broadly utilized, most probably because of the
depressed share prices and for investors (particularly with those investors who have low
marginal tax rates) it is very favourable tax implication. Similarly, Blakelock and King (2017)
stated that a company returns capital to their investors as capital and dividend, by way of the
dividend component usually significantly prevail over capital component, it is allowed by an off-
market share buy-back. This structure of companies allows them to attach a large amount of
franking credit with the dividend component of share buy-back.
An uncertain form of franking credits to value is future franking credits because it is not present
at valuation’s time. In this area, the majority of the study has been taken on for regulatory
purpose. The regulators of Australia of certain infrastructure assets put the correct return of
capital for the regulated asset’s owner, and it also contains regard towards the impact of franking
credits at the required rate of return.
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The market value of franking credits and dividends
The franking credit’s market value is, defined as what is the eagerness of investors of making
payment to get the franking credits, being the face value’s element. This is considered as the fall
in investor’s individual tax that conducts the calculation of the place of investors over franking
credits. Those investors willing to place full value on franking credit contain an individual theta
of 1; while that investor willing to pose no value over franking credits contain a theta of 0
(Blakelock and King, 2017). Therefore, the theta value obtains a theoretical based interval
0. In regards to determining a WACC of a firm, the suitable value of theta has to show a
weighted average of a personal valuation of all investors of franking credits. In this sense,
investors also seek to agree with the comparatively less required rate of return based on the
investments held on equity only when it is aligned with franking credits. All investors want to
agree with the diverse rate of return, but it is totally based on the personal valuation of franking
credit valuation. In the similar trend, Swan (2018) asserted that franking credits of investors are
less as compared to their face value, so, as to qualify the franking credits, an investor has to
obtain risk by holding or purchasing stock. Additionally, the domestic investors go without
taking the advantages of franking credits, and by qualifying for franking credits, investors earn
transaction costs. Consequently, the average required rate of return (RRR) is based on the
weighted average of per individual franking credit valuation of an investor (Toth and Burns,
2016).
Unfortunately, McClure and co-authors (2018) have stated that franking credits are not in use of
trade, because their prices seem to be non-obvious and observable on a direct basis.
Nevertheless, the market value of franking credit could be interpreted by monitoring in what
manner the stock’s market price has a reaction to the distribution of franking credits as well as
dividends. Under this condition, there would be a deduction in prices of stock through the market
value of franking credit paid as well as cash dividend (Cannavan and Gray, 2017).By the
execution of the author’s investigation, after a long time and across a huge number of dividend
actions, the franking credit’s average market value can be achieved.
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Methods of estimating
(i) Gamma in the Weighted Average Cost of Capital
The concept of franking credits shows rebate that decreases the individual liabilities upon tax
When the franking credit changes the effectual return on after-tax on the investment held on
equity; then required Return on equity (ROE) will be changed by the franking credits, required
by an investor (Beggs and Skeels, 2006). An ultimately theoretical structure provides that in
which manner the franking credit make changes in the after-tax cost of capital, as per the
planning of Officer 1994. The company’s operating income Earnings before Interest and Tax is
simply defined as below:
Here X0 stands for operating income, and abbreviation XG is for the share of operating income
by the government that is company taxation, and the XD denotes for the share of debtholder
from the operating income, and the last XE stands for the share of from the operating income.
The amount of Tx (X0-XD) is the company’s taxation amount that was collected from the source
of the company with the help of the government. Furthermore, a part of the same amount that
may be termed as γ (gamma), it stands for the tax that is assembled from a corporate and the
same will be rebated in opposition to the individual income tax. Further, it is suitable to consider
gamma being the percentage of individual income tax gathered at the level of corporate which
thereby gives increment to franking credits. Gamma is utilized for earlier payment of individual
tax liabilities (Hathaway &Officer 2004).
2. Dividend Drop Off
Dividend drop-off or DDO studies entails investigating the quantity of the stock price of a firm
that is altered subsequent to the ex-dividend. This study is totally conducted on the basis of the
supposition of perfect capital markets wherein; there is the absence of transaction costs and
different tax systems among capital gains and dividends. In addition, the share price is also not
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focused on influencing except the allocation of franking credits and dividends (Vo, Gellard,
Mero, and Authority, 2013). The study conducted by arbitrage calculates, by considering this
circumstance the estimated deduction of share price from cum-dividend day towards the ex-
dividend day must be equivalent to the gross dividend that contains franking credit value and the
cash dividend value. Nevertheless, the supposition of the perfect capital market is improbable to
be sustained actuality. Additionally, there is no full valuation of collective gross dividend
package by the investor; the estimated price drop-off must be lower as compared to the face
value. Officially, this declaration altered as:
Here, E| Pci-Pxi| is considered as the estimated price drop-off deducted from the day price of
cum-dividend, E| Pci-Pxi|, denotes the ex-dividend day price, the value placed by an investor in
terms of the cash dividend is denoted as Pxi. 1, Di is considered as the face value proportionate,
the value placed by an investor in the franking credit is the  2 and the FCI is the percentage of
its face value (Vo, Gellard, Mero, and Authority, 2013).
Conclusion
The literature concluded that franking credit averts “double dipping” through the government at
where the tax is paid on profits through both companies as well as an investor. The main
methods of estimating franking credits are Gamma in both Weighted Average Cost of Capital as
well as Dividend Drop Off. This study has concluded that international investors, who cannot
make use of franking credits in the direction of decreasing their individual liability on tax, and
pose no value upon franking credits consequently, an investor on a net value franking credit on
lower as compared to their face value.
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References
Beggs, D.J. and Skeels, C.L., 2006. Market arbitrage of cash dividends and franking
credits. Economic Record, 82(258), pp.239-252.
Blakelock, S. and King, P., 2017. Taxation law: The advance of ATO data
matching. Proctor, 37(6), p.18.
Cannavan, D. and Gray, S., 2017. Dividend drop-off estimates of the value of dividend
imputation tax credits. Pacific-Basin Finance Journal, 46, pp.213-226.
Market index, 2018. The Basics of Franking Credits. [Online] Available from
<https://www.marketindex.com.au/franking-credits>[Accessed on 4th October 2018]
McClure, R., Lanis, R., Wells, P. and Govendir, B., 2018. The impact of dividend imputation on
corporate tax avoidance: The case of shareholder value. Journal of Corporate Finance, 48,
pp.492-514.
Swan, P.L., 2018. Investment, the Corporate Tax Rate, and the Pricing of Franking Credits.
Toth, S. and Burns, A., 2016. Mid market focus: Company tax rates: Consider the total tax
liability. Taxation in Australia, 51(5), p.245.
Vo, D., Gellard, B., Mero, S. and Authority, E.R., 2013, April. Estimating the market value of
franking credits: Empirical evidence from Australia. In Conference Paper, Australian
Conference of Economists.
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